Farm Credit System: Repayment of Federal Assistance and Competitive
Position (Chapter Report, 03/10/94, GAO/GGD-94-39).
This report discusses the Farm Credit System's repayment of the federal
financial assistance provided in the late 1980s and its current and
future competitive position. In studying rural credit cost and
availability, GAO answers three main questions: (1) Whether and how the
federal financial assistance granted to the Farm Credit System will be
repaid? (2) What is the extent and fairness of competition between
System institutions and commercial banks? (3) Whether the System's
charter should be changed to permit diversification?
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-94-39
TITLE: Farm Credit System: Repayment of Federal Assistance and
Competitive Position
DATE: 03/10/94
SUBJECT: Farm credit
Banking regulation
Government sponsored enterprises
Capital
Agricultural policies
Lending institutions
Farm credit banks
Financial management
Accounting procedures
Bank management
IDENTIFIER: Farm Credit System
Agricultural Credit Insurance Fund
Bank Insurance Fund
BIF
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Cover
================================================================ COVER
Report to Congressional Committees and the Honorable Thomas A.
Daschle, U.S. Senate
March 1994
FARM CREDIT SYSTEM - REPAYMENT OF
FEDERAL ASSISTANCE AND COMPETITIVE
POSITION
GAO/GGD-94-39
Farm Credit System
Abbreviations
=============================================================== ABBREV
ABA - American Bankers Association
ACA - Agricultural Credit Association
APB - Accounting Principles Bulletin
ARB - Accounting Research Bulletin
BC - Bank for Cooperatives
CIPA - Contractual Interbank Performance Agreement
CPA - capital preservation agreement
FAC - Farm Credit System Financial Assistance Corporation
FASB - Financial Accounting Standards Board
FCA - Farm Credit Administration
FCB - Farm Credit Bank
FCSIC - Farm Credit System Insurance Corporation
FICB - Federal Intermediate Credit Bank
FLB - Federal Land Bank
FLBA - Federal Land Bank Association
FLCA - Federal Land Credit Association
GAAP - generally accepted accounting principles
GSE - government-sponsored enterprise
OMB - Office of Management and Budget
PCA - Production Credit Association
SAB - Staff Accounting Bulletin
SEC - U.S. Securities and Exchange Commission
SFAC - Statement of Financial Accounting Concepts
SFAS - Statement of Financial Accounting Standards
SPE - special purpose entity
USDA - U.S. Department of Agriculture
Letter
=============================================================== LETTER
B-251966
March 10, 1994
The Honorable Patrick J. Leahy
Chairman
The Honorable Richard G. Lugar
Ranking Minority Member
Committee on Agriculture, Nutrition,
and Forestry
United States Senate
The Honorable Kent Conrad
Chairman
The Honorable Charles E. Grassley
Ranking Minority Member
Subcommittee on Agricultural Credit
Committee on Agriculture, Nutrition,
and Forestry
United States Senate
The Honorable E (Kika) de la Garza
Chairman
The Honorable Pat Roberts
Ranking Minority Member
Committee on Agriculture
House of Representatives
The Honorable Tim Johnson
Chairman
The Honorable Larry Combest
Ranking Minority Member
Subcommittee on Environment,
Credit, and Rural Development
Committee on Agriculture
House of Representatives
The Honorable Thomas A. Daschle
United States Senate
This report discusses the Farm Credit System's repayment of the
federal financial assistance provided in the late 1980s and its
current and future competitive position. This report completes GAO's
response to the mandate in the Food, Agriculture, Conservation, and
Trade Act of 1990 (P.L. 101-624, 104 Stat. 3359) that required GAO
to study certain matters related to the cost and availability of
credit in rural America.
We are sending copies of this report to other appropriate
congressional committees and executive branch agencies, including the
Office of Management and Budget; the U.S. Department of Agriculture;
the Department of the Treasury; and the Farm Credit System; and to
other interested parties, such as the American Bankers Association.
Copies of this report will also be made available upon request.
Please contact me on (202) 512-8678 or William J. Kruvant, Assistant
Director, on (202) 728-5847 if you or your staff have any questions.
Major contributors to this report are listed in appendix VII.
James L. Bothwell
Director, Financial Institutions
and Markets Issues
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
The Food, Agriculture, Conservation, and Trade Act of 1990 mandated a
GAO study of rural credit cost and availability. The mandate
included 10 questions; this report addresses 8 of them. The
remaining two questions, concerning the availability of rural credit,
were addressed in another recent GAO report.\1
GAO distilled the eight questions into three objectives for the
study: (1) whether and how the federal financial assistance granted
to the Farm Credit System (System) will be repaid, (2) the extent and
fairness of competition between System institutions and commercial
banks, and (3) whether the System's charter should be changed to
permit diversification.
--------------------
\1 See Rural Credit: Availability of Credit for Agriculture, Rural
Development, and Infrastructure (GAO/RCED-93-27, Nov. 25, 1992).
BACKGROUND
---------------------------------------------------------- Chapter 0:2
The System is a government-sponsored enterprise (GSE). A GSE is a
private institution chartered by Congress to serve the public purpose
of facilitating the flow of funds to a particular sector of the
economy, in this case agriculture. The 14 banks and about 250
related local lending associations that the System comprises are
cooperatively owned by their member-borrowers. On December 31, 1992,
the System reported $63.2 billion in assets, including over $50
billion in outstanding loans. It holds one-fourth of the total U.S.
farm debt.
Farmers and their lenders experienced severe financial stress in the
mid-1980s. Congress passed the Agricultural Credit Act of 1987 in
response to the impact of this stress on the System. It authorized
up to $4 billion in federal financial assistance to the System and
required extensive structural and operational reforms. The 1987 act
also set up the Farm Credit System Insurance Corporation (FCSIC) to
insure System debt and to assist System institutions in the future,
if needed. FCSIC became fully operational on January 1, 1993.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
The reforms required by the 1987 act and an improving agricultural
economy have strengthened the System, whose business is now
profitable and stable. Barring another unexpected crisis in
agriculture, the System should be able to repay the $1.261 billion in
federal financial assistance it received when due early in the next
century.
Recent legislation clarified how System banks should accumulate funds
for repayment of the 1987 act assistance. However, this legislation
continues certain kinds of accounting and regulatory relief. Because
of these statutory provisions, neither the public nor the Farm Credit
Administration (FCA), the System's regulator, has completely accurate
information on System banks' progress toward financial recovery. GAO
believes that ending these types of relief would make System banks'
true financial position clearer and improve regulatory oversight.
GAO found that, as of December 31, 1992, all System banks could still
meet minimum regulatory capital standards if these actions were
taken.
The 1987 act required the Department of the Treasury to advance the
System interest-free funds to pay some of the interest on the bonds
issued to raise money for assistance. GAO believes that accounting
adjustments are needed to recognize this benefit--estimated to be
over $200 million--to System banks. These adjustments, if made,
would reduce the System's reported liabilities and, thus, increase
its combined capital.
The 1987 act also granted an initial capital infusion of $260 million
in taxpayer money to FCSIC. GAO believes that this money can and
should be returned to the Treasury so that FCSIC is entirely financed
by premiums collected from the System. Congress recently reaffirmed
this policy of "industry financing" of federal insurance for
commercial banks.
FCSIC's Insurance Fund is counted as a System asset and as System
capital in the System's combined financial statements. GAO believes
the System should remove FCSIC's Insurance Fund from its combined
balance sheet because FCSIC is a federal entity created to assist the
System. Since FCSIC is a government agency, its funds are part of
the government's budget and should not be counted as System capital.
GAO's analysis of relevant accounting rules showed that exclusion of
the Insurance Fund from the System's combined financial statements is
better supported by generally accepted accounting principles (GAAP)
than the current treatment. GAO found that removing FCSIC's
Insurance Fund from the System's balance sheet would leave the System
with a combined capital ratio of about 10 percent as of December 31,
1992, well above the 7-percent regulatory requirement. Removing the
Insurance Fund would have no impact on the financial reports of any
individual System bank.
GAO's economic analysis did not reveal evidence of unfair competition
by the System. While some System institutions have been lending
aggressively, FCA found that such lending was legitimate competition
in nearly all cases. GAO examined how FCA investigates complaints of
unfair competition and found that the investigations provide a
reasonable basis for FCA's conclusions. The System has some cost
advantages over small commercial banks. These advantages, however,
are the result of the System's GSE status, not unfair competitive
practices.
As a GSE, the System's charter is limited to ensure that it fulfills
its public policy purpose of serving agriculture. GAO found that the
System does not need to diversify beyond agriculture to remain viable
in the near term. However, as rural America's financial needs
evolve, the System's charter may need to be updated.
GAO'S ANALYSIS
---------------------------------------------------------- Chapter 0:4
SYSTEM SHOULD BE ABLE TO
REPAY 1987 ACT ASSISTANCE
-------------------------------------------------------- Chapter 0:4.1
The System used $1.261 billion of the $4 billion in assistance
authorized by Congress under the 1987 act. A temporary organization
created by the 1987 act, the Farm Credit System Financial Assistance
Corporation, raised the funds used for assistance by issuing
Treasury-guaranteed 15-year bonds. The money went to aid four Farm
Credit Banks, liquidate the Jackson Federal Land Bank, fund certain
obligations between banks incurred before the 1987 act, and for
miscellaneous authorized purposes. In addition, the Treasury must
advance an estimated $444 million to $580 million to pay as much as
one-third of the interest on the bonds issued to finance the
assistance package. System banks must reimburse the Treasury for
these advances in 2005, but are not required to pay interest on these
funds. This interest-free loan benefits the System by reducing the
burden of assistance repayment on System banks by over $200 million,
which is made up by taxpayers.
GAO's analysis of the System's financial condition indicates that
System banks can record their assistance obligations as liabilities
on their balance sheets and still meet new regulatory capital
requirements. In fact, two assisted Farm Credit Banks have paid off
their direct aid early. (See pp. 37 and 38.)
NEW LEGISLATION CONTINUES
ACCOUNTING AND REGULATORY
RELIEF FOR ASSISTANCE
REPAYMENT
-------------------------------------------------------- Chapter 0:4.2
By specifying how System banks should meet their assistance repayment
obligations, the Farm Credit Banks and Associations Safety and
Soundness Act of 1992 addresses one weakness of the 1987 act. The
1987 act was silent on mechanisms for accumulating funds to repay
assistance. The new law, however, continues to provide both
accounting and regulatory relief to the banks. (See pp. 36 to 40.)
System banks are not required to record liabilities for all of their
assistance repayment obligations. Since System banks do not record
liabilities for all obligations, their reported capital is greater
than their actual available capital.
For regulatory purposes, current law allows System banks to count
some of the annual assessments deposited with the Financial
Assistance Corporation toward assistance repayment as permanent
capital until shortly before repayment is required. The banks may
also delay making some of these payments to avoid falling below the
regulatory minimum for capital. Those that received direct aid can
continue to count both this assistance and the amounts they set aside
to repay it toward this minimum. These provisions allow the banks to
overstate their regulatory capital ratios. Thus, effective
regulatory oversight could be compromised.
GAO believes that continuing the accounting and regulatory relief for
assistance repayment is inappropriate and unnecessary. GAO's
analysis of the impact of eliminating it showed that no System bank
would incur serious financial stress or fail to meet regulatory
minimum capital requirements as of December 31, 1992.
FCSIC'S INITIAL GOVERNMENTAL
CAPITAL INFUSION SHOULD BE
REPAID
-------------------------------------------------------- Chapter 0:4.3
FCSIC has been charging premiums to System banks since 1989. As of
December 31, 1992, its insurance fund had a net balance of $488
million after subtracting FCSIC's obligation to pay some of the costs
of liquidating the Jackson Federal Land Bank.
The 1987 act transferred $260 million from the Treasury to FCSIC as
initial capital for the insurance fund with no requirement for
repayment. GAO believes that such insurance funds should be financed
from industry sources, not by the government, if at all possible.
Nonrepayment of the $260 million is inconsistent with past practice
and current policy for federal deposit insurance, which requires
insured commercial banks to take responsibility for this protection.
In addition, GAO notes that this nonrepayment is a departure from the
overall policy of the 1987 act that the System repay federal aid.
(See pp. 46 to 48.)
GAO examined what effect repaying the $260 million would have on
FCSIC. GAO's projections show that repayment would have only modest
effects--postponing achieving the goal for the size of the insurance
fund by 3 years (to 2001 instead of 1998).
INSURANCE FUND IS
INAPPROPRIATELY COUNTED AS A
SYSTEM ASSET
-------------------------------------------------------- Chapter 0:4.4
The System's combined financial statements include FCSIC's Insurance
Fund as an asset and as capital. GAO, the Office of Management and
Budget, and FCSIC agree that this is not appropriate. GAO's
reasoning is that FCSIC is a federal entity created to provide
assistance to the System. In addition, GAO does not believe
including FCSIC's Insurance Fund as an asset and as capital in the
System's combined financial statements is the most appropriate
treatment under GAAP. FCA had agreed with this position, but in
December 1993 it accepted a System proposal for additional disclosure
on the Insurance Fund in the notes to the System's combined financial
statements that, according to FCA, resolves its concerns.
By counting the Insurance Fund as an asset, the System is not well
positioned to benefit from future FCSIC assistance should the need
for such aid arise. This is because the replacement capital
available in the Insurance Fund is, under the System's current
accounting treatment, already counted as part of the System's
combined capital.
As of December 31, 1992, removing FCSIC's Insurance Fund from the
balance sheet would have left the System with combined capital of
over $6 billion. This translates to a capital ratio of about 10
percent, compared to about 11 percent if the Insurance Fund is
included. The adjustment will become larger if action is delayed
because the Insurance Fund will grow. Excluding the fund would have
no impact on the financial reports of any individual System bank.
(See pp. 48 to 51.)
IS THE SYSTEM AN UNFAIR
COMPETITOR?
-------------------------------------------------------- Chapter 0:4.5
Congress instructed the System to make loans at equitable and
competitive interest rates. The System's GSE status gives it cost
advantages. Thus, it has been able to offer loans at rates below
those charged by small rural banks (but not by large ones). However,
that does not mean that the System is an unfair competitor.
According to economic theory, an unfair competitor is one that sets
prices below its own cost and prevailing market rates in an effort to
damage its competition (often called "predatory pricing"). (See pp.
53 to 59.)
FCA scrutinizes System lenders' loan pricing during annual
examinations and investigates complaints of predatory pricing. GAO
reviewed all complaints of predatory pricing made to FCA between 1989
and 1991. GAO's review of the files supports FCA's view that none of
these complaints was justified. FCA did identify one case of
predatory pricing in a 1990 annual examination that did not arise
because of a complaint.
The Farm Credit System Assistance Board also monitored unfair
competition complaints against the banks it assisted. It did not
find examples of unfair competition by these banks.
SYSTEM AND COMMERCIAL BANK
INTEREST RATES
-------------------------------------------------------- Chapter 0:4.6
GAO compared System and commercial bank interest rates to see if the
System consistently offered loans at lower rates. (See pp. 62 to
67.) GAO found that the following interest rates were offered during
1991.
National average rates on operating loans varied from 8.1 percent
at large banks to 10.7 percent at small banks. System operating
loans were priced at 9.9 percent on average, fairly near the
middle of this range.
For real estate loans, large banks averaged 9.1 percent and small
banks 10.3 percent. System real estate loans averaged 9.5
percent.
Nationwide averages conceal much of the variation in local pricing.
This is important because rural banks and local System institutions
may compete in fairly small areas. Indeed, unfair competition
complaints have come mostly from agricultural banks in the Midwest.
GAO did two analyses of rates charged by banks and System
institutions in local midwestern markets. The first, for 10 local
market areas, showed that most of the System institutions charged
less on operating loans at least some of the time in 1991, and none
charged higher rates. The second analysis was a statistical test
covering a broader midwestern area. This test showed that the System
charged an average of 0.59 percentage points less on operating loans
and 0.99 percentage points less on real estate loans than small
midwestern banks.
DOES THE SYSTEM NEED TO
DIVERSIFY?
-------------------------------------------------------- Chapter 0:4.7
The System's charter is generally limited to serving agriculture.
There have been proposals to expand the System's charter to diversify
its loan portfolio to increase safety and reduce risk. There have
been small expansions of the System's powers, but in no case have the
actual or proposed changes been major ones. (See pp. 68 to 71.)
The System's current stability suggests that it does not need
expanded powers to promote safety and soundness in the near term.
However, rural America's economy is changing. It is shifting away
from relying on agriculture and other natural resource industries.
At some point, the System's charter may also need to be updated and,
if judged desirable in the context of the nation's rural development
agenda, expanded to reflect these changes.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 0:5
GAO recommends that Congress
require that System institutions record all categories of
assistance granted under the 1987 act using the GAAP that best
reflects the economic substance of this federal aid;
provide FCA statutory authority to recognize all categories of 1987
act assistance as temporary, not permanent, capital of System
banks for regulatory purposes; and
require FCSIC to reimburse the Treasury for its initial capital
infusion of $260 million within a reasonable time, taking the
financial condition of the System and the Insurance Fund into
consideration.
GAO recommends that FCA require the System to exclude FCSIC's
Insurance Fund from its combined financial statements.
AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6
GAO requested comments on a draft of this report from the System,
FCA, FCSIC, and the American Bankers Association. All four
organizations provided written comments, which are summarized and
evaluated in chapter 5 and reproduced in appendixes III through VI.
The commenters expressed widely varying opinions on GAO's analysis,
conclusions, and recommendations. This final report includes
additional analysis, which further supports GAO's positions.
1987 ACT ASSISTANCE
REPAYMENT AND FCSIC ISSUES
-------------------------------------------------------- Chapter 0:6.1
The System took strong exception to GAO's positions on the assistance
repayment and FCSIC issues discussed in chapter 2, and disagreed with
all of GAO's recommendations. FCA, FCSIC, and the American Bankers
Association generally agreed with GAO's conclusions and supported
GAO's recommendations on these issues.
The System affirmed its support for the assistance repayment
framework of the 1992 act. GAO agrees that the 1992 act cleared up
important issues, such as how System banks should meet and record
their assistance obligations, but GAO continues to believe that the
overall framework for assistance repayment can and should be further
improved. FCA and FCSIC generally agreed with this position. The
American Bankers Association also agreed with these recommendations
without comment.
The System urged GAO to withdraw or modify its recommendations
regarding FCSIC and the Insurance Fund. In particular, the System
urged GAO to recommend that FCA and the System jointly submit the
question of how the System should account for the Insurance Fund to
the Emerging Issues Task Force of the Financial Accounting Standards
Board for resolution. In December 1993, FCA formally accepted a
System proposal for additional disclosure on the treatment of the
Insurance Fund as System assets and capital in the notes to the
System's combined financial statements. According to FCA, this
revised form of disclosure on the Insurance Fund resolves its
concerns. GAO still believes that this matter needs resolution
because it allows the System's financial statements to be
inconsistent with FCSIC's concerning the Insurance Fund. GAO also
believes that treating FCSIC's Insurance Fund as a System asset and
as System capital is inappropriate, both from a public policy and an
accounting standpoint.
GAO includes additional analysis of FCSIC issues in appendix I to
this final report in response to System, FCA, and FCSIC comments.
Both FCA and FCSIC supported GAO's recommendations on accounting for
the Insurance Fund, but suggested further analysis be done before
they are implemented. (As noted above, FCA has since resolved the
FCSIC accounting issue to its satisfaction.) The American Bankers
Association also supported these recommendations on the basis that
implementing them would promote fairer competition between the System
and commercial banks.
UNFAIR COMPETITION
-------------------------------------------------------- Chapter 0:6.2
The American Bankers Association was critical of GAO's analysis of
the predatory pricing controversy and urged GAO to reassess its
conclusions. ABA's concerns were (1) what predatory pricing
definition was actually used for GAO's analysis; (2) FCA's definition
of predatory pricing, which ABA contends is contrary to applicable
law; and (3) whether the proper economic analysis was used on
competition from GSEs. The System stated that it fully concurred
with GAO's conclusions. FCA had no comment. FCSIC questioned GAO's
conclusion that the System's status as a GSE gives it a cost of funds
advantage over commercial banks. GAO clarified certain aspects of
its analysis of predatory pricing in this final report, but GAO's
position on this issue is unchanged.
EXPANDING THE SYSTEM'S
CHARTER BEYOND AGRICULTURE
-------------------------------------------------------- Chapter 0:6.3
The American Bankers Association had further reservations about GAO's
review of issues surrounding an expansion of the System's charter
beyond agriculture. It suggested that GAO focus on whether the
System is still necessary to support agriculture, adding that, in its
view, the System should be allowed to decline naturally if the answer
to this question is no. The System offered additional arguments in
support of expanding its powers, but took the position that, overall,
there was little that was controversial in GAO's analysis. FCA
stated that more work needs to be done to arrive at a final public
policy position on expanded powers for the System. FCSIC had no
comment. GAO acknowledges these differing views in the text of this
final report.
INTRODUCTION
============================================================ Chapter 1
U.S. agriculture underwent a financial crisis in the 1980s following
a decade of prosperity. During the 1970s, export markets for farm
products grew rapidly, crop yields were good, commodity prices were
high, and real interest rates were low. Optimistic about their
future incomes and with rapid rises in their land values, farmers
borrowed heavily to buy new equipment and increasingly expensive
farmland. As late as 1980 and 1981, experts were predicting
continued agricultural prosperity. Subsequent events, however,
proved these predictions wrong as the positive trends abruptly
reversed themselves.
Many farmers were unable to pay their debts. As the value of the
collateral securing these debts declined, more agricultural banks
failed than at any time since the Great Depression of the 1930s.
Unprecedented losses prompted federal financial assistance to the
Farm Credit System (System) as well as major structural and
operational reforms. Beginning in 1987, increased government
spending on farm programs and improved market conditions sparked an
agricultural recovery. In recent years, agricultural banks have been
among the most profitable in the banking industry. The System is
also recovering, although some System institutions are still in
transition.
The Food, Agriculture, Conservation, and Trade Act of 1990 (P.L.
101-624, 104 Stat. 3359) required us to conduct a 10-point study of
certain matters related to the cost and availability of credit in
rural America. This report addresses the eight questions on the cost
of credit and competition between the major lenders to agriculture:
the System, commercial banks, and insurance companies.\1 Chapter 2
describes how the federal assistance to the System was used and how
it will be repaid. Chapter 3 covers the controversy over the loan
pricing practices of the System and others. Finally, chapter 4 looks
at the role and mission of the System and the issue of expanding it
beyond agriculture.
--------------------
\1 Another recent GAO report addressed the other two questions, which
focus on the availability of credit. See Rural Credit: Availability
of Credit for Agriculture, Rural Development, and Infrastructure
(GAO/RCED-93-27, Nov. 25, 1992).
BACKGROUND
---------------------------------------------------------- Chapter 1:1
The System is a government-sponsored enterprise (GSE). System
institutions are now privately owned, but the System was chartered by
Congress to serve the public purpose of facilitating the flow of
funds to agriculture.\2 System institutions are cooperatives; they
are owned by member-borrowers who must buy stock as a prerequisite
for borrowing. On December 31, 1992, the System reported $63.2
billion in assets and had $52.4 billion in loans on its books. The
System holds about one-fourth of total U.S. farm debt, or
approximately $35 billion of the $140 billion reported in recent U.S.
Department of Agriculture (USDA) statistics. The System also lends
to agricultural cooperatives, rural utilities, rural homeowners, and
others.
Like other GSEs, the System raises funds on the national capital
markets at a relatively low cost on the strength of its ties to the
federal government. Its banks are jointly and severally liable for
the Systemwide debt securities they issue through the Federal Farm
Credit Banks Funding Corporation (Funding Corporation). The System
currently includes 14 operating banks, about 250 related local
lending associations, and several national coordinating organizations
and committees. Figure 1.1 shows how the System is overseen and
organized. The Farm Credit Administration (FCA), an independent
federal agency, is the System's regulator.\3
Figure 1.1: How Farm Credit
System Is Overseen and
Organized
(See figure in printed
edition.)
\a The Farm Credit System Assistance Board terminated on December 31,
1992, as provided for in the Agricultural Credit Act of 1987.
\b This entity provides leasing and related services to eligible
System borrowers, including agricultural producers, cooperatives, and
rural utilities.
\c These standing committees include the Presidents Planning
Committee, which is composed of the presidents of System banks, the
Funding Corporation, and the Farm Credit Council. This committee is
not subject to federal oversight.
Source: Prepared by GAO.
(See figure in printed
edition.)
The core of the System was established between 1916 and 1933.
Historically, the System was organized in 12 districts, each of which
contained 3 legally distinct types of banks supported by 2 types of
associations. In 1916, Federal Land Banks (FLB) and related
associations, later known as Federal Land Bank Associations (FLBA),
were authorized. Federal Intermediate Credit Banks (FICB) were set
up in 1923, and related Production Credit Associations (PCA) were
authorized in 1933. Also in 1933, 12 district Banks for Cooperatives
(BC) and a Central Bank for Cooperatives were created. The federal
government provided start-up capital for all System institutions.
After the start-up funds were fully repaid by the FICBs, PCAs, and
BCs in 1968, the amounts remained available to FCA in revolving funds
to make temporary capital stock investments in these institutions if
necessary.
The Farm Credit Act of 1971 (P.L. 92-181, 85 Stat. 583) codified
the law governing the System and updated and expanded its charter.
Responding to the System's financial crisis, Congress made important
amendments to this law in 1985 and 1986 and when it passed the
Agricultural Credit Act of 1987 (P.L. 100-233, 101 Stat. 1568).\4
The 1987 act mandated certain structural changes in the System and
encouraged others. It required all FLBs and FICBs to merge to form
Farm Credit Banks (FCB), permitted the BCs to consolidate, and
allowed other mergers between banks. The number of operating banks
has since dropped from 37 to 14. The 1987 act also encouraged FLBAs
and PCAs that shared substantially the same geographical territory to
merge into a new type of association known as an Agricultural Credit
Association (ACA). FLBAs could convert to Federal Land Credit
Associations (FLCA) and become direct lenders to farmers like other
types of System associations rather than act as agents for FCBs. The
number of associations had fallen from over 400 in the mid-1980s to
246 as of October 1, 1992. Figure 1.2 is a map of the System banks
and their related associations.
Figure 1.2: Map of Farm Credit
System Banks and Associations
by District as of October 1,
1992
(See figure in printed
edition.)
\a AgriBank was formed in May 1992 from the merger of the St. Louis
and St. Paul FCBs, resulting in 11 System districts.
\b The Western FCB also funds a PCA in eastern Idaho.
\c The Texas FCB makes long-term loans in Alabama, Louisiana, and
Mississippi. It also funds certain PCAs in New Mexico.
\d The Jackson FLB is in receivership. The Jackson FICB merged with
the Columbia FCB in 1993.
Source: FCA data.
(See figure in printed
edition.)
--------------------
\2 The System is not a single legal entity, but it is often referred
to as "a GSE" for convenience, as we do in this report. The major
GSEs are financial institutions chartered by Congress to achieve the
public purposes of facilitating the flow of funds to agriculture,
housing, and higher education. In addition to the System, these
enterprises are the Federal National Mortgage Association (Fannie
Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), the
Federal Home Loan Bank System, and the Student Loan Marketing
Association (Sallie Mae).
\3 FCA also regulates the Federal Agricultural Mortgage Corporation
(Farmer Mac). Farmer Mac was created in 1988 to sponsor a secondary
market in agricultural real estate loans. While Farmer Mac is a
System institution, its operations are completely separate from those
of System banks and associations.
\4 Other amendments were made between 1989 and 1992. When we refer
to the "Farm Credit Act" in this report, we mean the Farm Credit Act
of 1971, as amended.
FEDERAL ASSISTANCE TO THE
SYSTEM DURING THE MID-1980S
---------------------------------------------------------- Chapter 1:2
The System experienced severe financial stress in the mid-1980s. The
problems came from a combination of external and internal factors:
deterioration in agriculture, increased volatility of interest rates,
and poor management practices. In 1985, the System reported a record
$2.7 billion loss, followed by a $1.9 billion loss in 1986, prompting
a qualified opinion from its external auditors as to its ability to
continue operating without assistance.
FCA established the Farm Credit System Capital Corporation (Capital
Corporation) in June 1985 to administer contractual loss
sharing/capital preservation agreements between System banks.
Amendments to the Farm Credit Act passed in December 1985 formalized
the Capital Corporation and authorized it to receive and administer
federal financial assistance from the Treasury. Such assistance
would have had to be appropriated by Congress. These amendments also
authorized FCA to use amounts available in the revolving funds
discussed earlier--combined into a single fund of $260 million--to
purchase stock in the Capital Corporation. Before the 1985
amendments were enacted, the System's cost of issuing debt had
increased dramatically relative to that of other GSEs. It quickly
fell once this federal support for the System was made available.
The 1985 amendments provided that federal assistance was only to be
considered after the System's surplus (retained earnings) was so low
that further contributions from stronger System banks or losses at
weaker ones would likely preclude them from making credit available
on reasonable terms. The stronger System banks transferred over $1
billion to weaker ones during 1985 and 1986. However, several
healthy System institutions challenged in court the requirement that
they subsidize unprofitable institutions they did not control. In
some instances, the courts upheld the challenges. By mid-1986, the
System's cost of funds had again begun to rise, reflecting continuing
losses and investors' uncertainty over whether the federal assistance
authorized by the 1985 amendments would, in fact, be provided.
In October 1986, Congress again amended the Farm Credit Act. These
amendments, among other things, authorized System banks to delay
recognition of certain expenses and losses and to disregard generally
accepted accounting principles (GAAP) in doing so.\5
We reported that we had serious reservations about relying on
legislatively sanctioned regulatory accounting to deal with the
System's problems. We wrote that it could not only seriously
overstate the earnings of System banks, but also slow reforms in
management practices and operations.\6 In fact, the accounting relief
did not substantially delay the need for federal financial
assistance.
The System was able to continue borrowing throughout its financial
crisis, but only at a relatively higher cost than it had
historically. The rates on the System's 6-month securities peaked at
roughly 115 basis points over comparable Treasury securities in 1987
before a new set of federal assistance mechanisms became law.\7 In
the 1987 act, Congress authorized issuing up to $4 billion in
Treasury-guaranteed bonds to fund assistance to the System. It also
required the Treasury to advance some of the interest payments on
these bonds. Bonds worth $1.261 billion were actually issued and
must be repaid along with Treasury interest advances estimated at
$444 million to $580 million. The 1987 act established two
temporary, special-purpose entities to carry out the assistance
program. It also chartered another new entity to insure the System's
debt and to provide assistance to troubled institutions in the
future, if needed. These entities, which are discussed further in
chapter 2, are described below.
--------------------
\5 The System began preparing its combined financial statements using
GAAP at year-end 1985 and has continued to do so since that time.
\6 See Farm Credit: Actions Needed on Major Management Issues
(GAO/GGD-87-51, Apr. 1, 1987).
\7 See pp. 83-89 of our previous report, Government-Sponsored
Enterprises: The Government's Exposure to Risks (GAO/GGD-90-97, Aug.
15, 1990), for a more complete discussion of how GSEs' federal ties
influence their ability to continue borrowing even when they
experience serious financial difficulties and are perceived to be in
danger of failing. On p. 88 of that report, we presented a graph
illustrating the System's and Fannie Mae's cost of funds relative to
comparable Treasury debt between 1980 and 1989.
TWO TEMPORARY ENTITIES CARRY
OUT 1987 ACT ASSISTANCE
PROGRAM
-------------------------------------------------------- Chapter 1:2.1
The Farm Credit System Assistance Board (Assistance Board) was the
successor to the Capital Corporation and sunset on December 31, 1992.
Unlike the Capital Corporation, the Assistance Board was independent
of both the System and its regulator. Its board of directors was
composed of the Secretaries of Agriculture and the Treasury and a
farmer nominated by the President and confirmed by the Senate. The
Assistance Board aided four FCBs: Louisville, Omaha, St. Paul, and
Spokane. It also authorized assistance for the liquidation of the
Jackson FLB. FCA placed this bank in receivership in May 1988 at the
Assistance Board's request.
With the approval of the Assistance Board, the Farm Credit System
Financial Assistance Corporation (FAC), the other temporary
organization, raised the funds used for assistance by issuing
Treasury-guaranteed 15-year bonds. FAC is a System institution with
the same board of directors as the Funding Corporation. When FAC's
authority to issue debt expired on September 30, 1992, it had raised
$1.261 billion. FAC, not the individual System banks and
associations, booked the liability for this debt. However, the law
contemplates that System banks will provide the funds to repay it.
In 2005, System banks must also repay the Treasury for advancing up
to $580 million or about one-third of the interest payments on these
bonds. They are responsible for the remaining interest payments when
due. The amount of interest to be advanced by the Treasury depends
on the System's overall financial condition between now and the year
2000. FAC estimated in 1991 that the Treasury interest advances will
add up to only $444 million, but they could be as much as $580
million. These advances provide an economic benefit to the System
and involve a corresponding cost to taxpayers that we estimate at
over $200 million. The recent Farm Credit Banks and Associations
Safety and Soundness Act of 1992 (P.L. 102-552, 106 Stat. 4102),
among other things, authorizes a new assistance repayment plan.
INSURANCE CORPORATION BECAME
FULLY OPERATIONAL IN 1993
-------------------------------------------------------- Chapter 1:2.2
The 1987 act also established the Farm Credit System Insurance
Corporation (FCSIC). It insures the debt issued by the System and
may provide financial assistance to troubled System institutions in
the future. FCSIC's board of directors consists of the same persons
that make up FCA's board.\8 FCSIC became fully operational on January
1, 1993, after the Assistance Board terminated. System banks have
been paying premiums to build up the Farm Credit Insurance Fund
(Insurance Fund), which FCSIC controls, since 1989. The Insurance
Fund has, in effect, already been tapped to liquidate the Jackson
FLB.
The 1987 act provided that the "joint and several liability" of the
System banks for Systemwide debt securities cannot be invoked until
the Insurance Fund is exhausted. In other words, an individual
System bank may still be called on to absorb losses incurred by
another bank, but only after all the money in the Insurance Fund has
been used. Thus, the Insurance Fund is the first but not the only
source available to cover such losses. The target or "secure base"
amount of the Insurance Fund is 2 percent of insured obligations or
about $1.1 billion based on the current level of insured System
obligations. FCSIC may set a different target size for the Insurance
Fund if necessary to make it "actuarially sound." As discussed
further in chapter 2, with premium and investment income of over $100
million annually, we project the Insurance Fund could reach its
secure base by 1998, if no further claims are made. The Insurance
Fund had a net balance of $488 million as of December 31, 1992.
The balance of the Insurance Fund was reduced in 1990 when FCSIC
booked a liability in anticipation of repaying a significant portion
of the $388 million in FAC debt issued to liquidate the Jackson
FLB.\9 The balance remained positive, however. This was due to the
premiums which had accrued and because $260 million of taxpayer
money--the amount in the revolving fund previously available to FCA
to help assist the System through the Capital Corporation--had been
transferred to FCSIC as initial capital in 1989. Unlike the other
federal assistance provided to the System under the 1987 act, there
is no provision for repaying this amount.
--------------------
\8 The chairman of FCSIC's board cannot be the same person as the
chairman of FCA's board, however. FCSIC's board will consist of
different persons than FCA's board beginning in 1996. By law, no
members of either FCSIC's or FCA's board can be affiliated with any
System institution.
\9 According to our projections, FCSIC will have to repay about $250
million of this debt. (See ch. 2.)
CAUSES OF THE SYSTEM'S
FINANCIAL STRESS
---------------------------------------------------------- Chapter 1:3
The System participated in the 1970s agricultural boom, experiencing
dramatic increases in loan volume and market share. Between 1971 and
1982, farm debt held by the System rose from $14.2 billion to a high
of $69.2 billion, and its market share increased from 25 percent to a
peak of 34 percent. As figure 1.3 shows, the System was the largest
agricultural lender during much of this period.
Figure 1.3: Historical Market
Shares of Major Agricultural
Lenders, 1945-1992
(See figure in printed
edition.)
Source: USDA.
Two factors contributed to the System's growth. First, the Farm
Credit Act liberalized collateral requirements for System loans.
Like many other agricultural lenders, many System institutions
decided how much to lend based more on the value of the collateral
(such as land) securing the loan than on the borrower's ability to
make loan payments from current income. Second, and perhaps more
importantly, the System sought a larger market share by offering
interest rates below those of its competitors.
System institutions priced loans based on the average or historical
cost of their outstanding debt, not the marginal or current cost of
funds as most other lenders do. Also, most System institutions
offered a single rate for each type of loan to all borrowers,
regardless of their creditworthiness. FCA approved all System loan
rates in advance. Market interest rates generally rose during the
1970s and early 1980s. But average-cost pricing allowed the System
to offer loans with rates well below those of its competitors. For
example, in 1980, System rates on operating loans averaged 12.74
percent--more than 2 percentage points lower than the 15-percent
average rate charged by small commercial banks. As a result, the
System's loan volume and market share grew rapidly.
The System financed this increased loan volume partly by issuing
long-term, fixed-rate, noncallable securities. However, most System
loans carried monthly variable rates, and borrowers could prepay them
without penalty. When market interest rates declined in the
mid-1980s, many System banks were locked into high-cost debt and
could not lower variable loan rates enough to remain competitive
without incurring heavy losses.\10 As a result, many of the most
creditworthy borrowers left the System and refinanced their loans
elsewhere.
The 1986 amendments to the Farm Credit Act removed FCA's authority to
approve System loan rates. This change was consistent with the 1985
amendments, which established FCA as an independent, "arm's-length"
regulator. The 1986 amendments also, in effect, allowed System banks
to use regulatory accounting to mask the impact of the high-cost debt
on their books and thereby lower loan rates. However, the policy
section of the 1986 amendments provided that the System should not
use this new flexibility or regulatory accounting to lower its rates
below competitive market levels. The System soon abandoned
average-cost pricing and offering one rate to all borrowers in favor
of "differential pricing" programs. Most System institutions now
take borrowers' relative creditworthiness into account in setting
loan rates, which are based on their current cost of funds.
As we previously reported, the System has made a serious effort to
improve its asset/liability management practices, which include loan
pricing practices.\11 Complaints from other agricultural lenders
about unfair or unsafe System loan pricing practices persist,
however. Most complaints are based on the competitive advantages
that accrue from the System's GSE status or on the fact that System
banks have been granted regulatory and accounting relief for their
assistance repayment obligations. We explore this controversy
further in chapter 3.
--------------------
\10 In September 1986, about $30 billion or half of outstanding
System debt carried interest rates of 10 percent or more. By that
time, interest rates on new System bonds had fallen to about 7.5
percent. Most of this high-cost debt has either matured or has been
retired--only about $3 billion remained outstanding in late 1992, or
about 5 percent of System liabilities. Most of the direct assistance
provided to the four FCBs was used to pay the premiums and associated
costs necessary to restructure high-cost debt.
\11 See Government-Sponsored Enterprises: The Government's Exposure
to Risks (GAO/GGD-90-97, Aug. 15, 1990).
SYSTEM'S FINANCIAL CONDITION
HAS IMPROVED
---------------------------------------------------------- Chapter 1:4
The amount of debt farmers owed shrank by about one-third during the
mid-1980s, with the System experiencing a larger decline than others.
Total farm debt has stayed at about $139 billion to $140 billion for
the past several years and is expected to grow only slowly in the
1990s. Although the System is no longer the largest agricultural
lender, its loan volume and market share have now stabilized.
Beginning in 1989, the System began to show profits from its lending
operations. Reported net income was $695 million in 1989, increasing
to $986 million in 1992. Reported returns on assets ranged from
about 1 percent in 1989 to 1.57 percent in 1992. These returns are
roughly comparable to those of the commercial banks that lent heavily
to agriculture during this period. This improvement in core earnings
has enabled the System to rebuild its capital base. All System banks
and all associations reported compliance as of June 30, 1992, with
FCA's new 7-percent minimum regulatory capital adequacy standard.
This standard became final on January 1, 1993, when a 5-year phase-in
period ended.
Although we identified some questionable accounting and regulatory
treatments that we believe have overstated earnings and capital
levels, there has been real improvement in the System's financial
condition and performance. To encourage continued improvement, all
System banks signed a Contractual Interbank Performance Agreement
(CIPA) that became effective on January 1, 1992. CIPA establishes
performance standards for the banks to achieve by the year 2000.
According to System officials, CIPA standards are comparable to those
nationally recognized rating organizations use to assign "A-" ratings
to debt issued by commercial banks. In 1990, the Treasury proposed
that all GSEs operate so as to obtain the highest available "AAA"
ratings to reduce risk to the federal government. The System
responded that it would be virtually impossible for it to do so
because lending to agriculture is considered a high-risk business.
We review some of the issues surrounding an expansion in the System's
charter beyond agriculture in chapter 4.\12
--------------------
\12 When we refer to the "System's charter" in this report, we mean
the basic charter of the System as described in the Farm Credit Act.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:5
As noted above, we prepared this report in response to eight
legislatively mandated questions on the cost of credit in rural
America. We distilled the eight questions into three objectives for
this study: (1) whether and how the federal financial assistance
granted to the System will be repaid; (2) the extent and fairness of
competition between commercial banks and System institutions, the two
largest providers of agricultural credit; and (3) whether the
System's charter should be changed to permit diversification. We met
several times to discuss our approach with two trade organizations
that represent the System and commercial banks: the Farm Credit
Council and the American Bankers Association (ABA). We also met with
staff of the USDA Economic Research Service and other academic
researchers, to discuss the agricultural credit market in general,
and reviewed recent USDA and other publications.
To answer the questions concerning assistance repayment, we reviewed
the statutes and legislative history on assistance, previous GAO and
other studies (see Related GAO Products at the end of this report),
and records of pertinent congressional hearings. We then did work at
FCA, the Assistance Board, FAC, the Funding Corporation, FCSIC, and
selected System banks, including three of the four assisted FCBs. In
doing this work, we had numerous discussions with officials and
reviewed relevant documents such as correspondence, memoranda,
agreements, legal and accounting opinions, minutes of board meetings,
business plans, and financial statements and examination reports for
the years 1989 to 1992. We also discussed assistance repayment
issues with an official of the Office of Management and Budget (OMB).
To prepare our response to agency comments on a draft of this report,
specifically the System's, FCA's, and FCSIC's comments on Insurance
Fund accounting issues, we prepared an analysis of relevant
accounting literature and had discussions with officials of these
organizations. This analysis is presented in appendix I.
To address the questions on competition, we analyzed management and
regulatory information on the loan pricing practices of the System,
commercial banks, and insurance companies. We focused on the Midwest
because most complaints of unfair competition against System
institutions originated there. We reviewed these complaints for the
years 1989 through 1991 at FCA and the Assistance Board as well as
selected FCA examination reports on System banks and associations for
the same period. We also interviewed officials and received data on
loans made during 1991 from the FCBs in St. Louis, St. Paul, and
Omaha. We obtained data on loans made by commercial banks operating
in the Midwest for the same year from the Federal Reserve Board. Our
statistical analysis of the 1991 data is discussed further in
appendix II. In addition, we met with representatives of the
Nebraska Bankers Association and the Nebraska Independent Bankers'
Association to discuss their March 27, 1990, testimony on "predatory
pricing" by System institutions. We discussed this testimony with
System and FCA officials. We also interviewed officials at
commercial banks that are members of state banking organizations
affiliated with ABA in Illinois, Kansas, and Wisconsin. To get the
perspectives of insurance companies, we interviewed officials at five
of the six companies that have at least $1 billion in agricultural
loans outstanding.
To answer the question on diversification by changing the System's
charter, we reviewed the statutes and regulations that govern it as
well as records of recent congressional hearings and legislative
proposals. We also discussed these proposals with the Farm Credit
Council and ABA.
The System, FCA, FCSIC, and ABA provided written comments on a draft
of this report. These comments are presented and evaluated in
chapter 5 and are reprinted in appendixes III through VI.
We did our work between July 1991 and July 1993 in accordance with
generally accepted government auditing standards.
FEDERAL ASSISTANCE TO THE SYSTEM
AND REPAYMENT PLANS
============================================================ Chapter 2
The Farm Credit Banks and Associations Safety and Soundness Act of
1992 sets up mechanisms for repayment of the federal assistance the
System received in the mid-1980s. Under the 1992 act, System banks
must periodically deposit funds with FAC toward the eventual
repayment of much of this assistance. The new law clears up some
important issues, but accounting and regulatory weaknesses remain.
We make recommendations to address these weaknesses. We recommend
that Congress require reimbursement of the initial infusion of $260
million in taxpayer money that was transferred to FCSIC as start-up
capital for the Insurance Fund. Not doing so is inconsistent with
Congress' policy requiring "industry financing" of federal insurance
funds by other financial institutions. It is also a departure from
the 1987 act's overall policy that the System repay federal
assistance.
In addition, we agree with OMB and FCSIC that the insurance premiums
System banks pay to FCSIC do not belong to the System. The insurance
premiums are not amounts voluntarily set aside as "self insurance" as
the System suggests. FCA had agreed with this position until
recently when it accepted a System proposal for revised disclosure on
the Insurance Fund in the notes to the System's combined financial
statements that, according to FCA, resolves its concerns. In
considering this insurance premium issue, we recommend that FCA
require that FCSIC's Insurance Fund be excluded from the System's
combined financial statements. Acting on this recommendation would
reduce the System's reported combined capital, but would better
position the System to benefit from FCSIC assistance in the future if
the need for such aid arises.
Overall, making the changes we recommend would, according to our
estimates, have still left the System with a combined capital ratio
of over 10 percent as of December 31, 1992. Going forward, we
believe taking action to resolve the accounting issues surrounding
FCSIC's Insurance Fund is particularly important. If this is not
done, we believe the System's combined earnings, assets, and capital
for 1993 and beyond may be materially overstated.
FEDERAL ASSISTANCE TO THE
SYSTEM UNDER THE 1987 ACT
---------------------------------------------------------- Chapter 2:1
The 1987 act set up a complicated framework for federal financial
assistance to the System involving the Assistance Board, FAC, the
Treasury, System banks and associations, and FCSIC. It authorized
FAC, with Assistance Board approval, to issue up to $4 billion in
15-year, Treasury-guaranteed bonds to fund the assistance. The 1987
act also required the Treasury to advance additional funds to cover
some of the interest payments on these bonds. FAC issued $1.261
billion in bonds, paying a weighted average interest rate of about
9.24 percent to investors. We estimate the effective cost to the
System to be under 7 percent, assuming it repays the assistance by
2005 as anticipated.
The System's combined financial statements do not clearly present
certain benefits of the 1987 act program. The 1987 act allowed the
System banks that received most of the assistance--about two-thirds
of the total--to treat it as a capital investment by FAC. By law,
System banks are, in effect, allowed to postpone paying dividends on
FAC's capital investment in individual banks. During the first 10
years this investment is outstanding, the Treasury must advance an
estimated $444 million to $580 million to FAC so that it can, in
turn, make interest payments to investors in the debt issued to raise
money to buy stock in troubled System banks. All System banks must
eventually provide funds to reimburse the Treasury for these
advances, but they are not required to pay for the use of these
funds. Thus, taxpayers are providing an economic benefit to System
banks that reduces the effective cost of capital assistance to about
6 percent. Paying for this form of aid also involves System "self
help": by law, directly assisted System banks must pay a share of
the cost of capital assistance, and other System banks must make up
the difference. When the 9.42-percent rate on the remaining
assistance and FCSIC's obligation to absorb some of the costs of the
Jackson FLB liquidation are taken into account, the effective cost to
all System banks of repaying the federal aid provided under the 1987
act can be estimated at about 6.81 percent.
The economic benefit to the System associated with the Treasury
interest advances involves a corresponding cost to taxpayers since
these funds cannot be used now for other public purposes, even if
System banks repay them later as planned. Currently, we estimate the
benefit to the System at $229 million to $264 million. The ultimate
benefit depends primarily on the total amount of interest (or
dividend) payments the Treasury makes on System banks' behalf. This,
in turn, depends on the financial condition of the System as a whole
over the next few years. As the System's condition improves, this
benefit declines. The ultimate cost to taxpayers depends not only on
these factors, but also on market interest rates. Currently, we
estimate this cost at $209 million to $243 million.
When FAC invested in troubled System banks, these banks reported an
increase in capital. However, all System banks were granted
accounting and regulatory relief under the 1987 act that allowed them
to avoid reflecting the costs of the assistance program in their
individual financial statements. Our analysis shows that all System
banks have now recovered to the point that they can fully acknowledge
their assistance repayment obligations.
HOW ASSISTANCE WAS FUNDED
-------------------------------------------------------- Chapter 2:1.1
FAC issued $1.261 billion of debt to fund assistance to the System
before its statutory authority to do so expired on September 30,
1992. This debt consists of several FAC bonds, all issued between
July 1988 and September 1990. Table 2.1 shows the issue dates,
interest rates, principal amounts, and maturity dates of these bonds.
Table 2.1
Cost of Bonds Issued to Fund 1987 Act
Assistance
Interest Principal
rate amount
(percent (in Maturity
Issue date ) millions) date
------------------------ -------- ---------- ------------
July 1988 9.375 $450 July 2003
November 1988 9.45 240 November
2003\a
April 1989 9.50 157 April 2004\a
June 1990 8.80 325 June 2005
September 1990 9.20 89 September
2005\a
============================================================
Wtd. avg./Total 9.24 $1,261
------------------------------------------------------------
\a These FAC bonds, a total of $486 million, are callable in whole or
in part at par after 10 years.
Source: GAO.
HOW ASSISTANCE WAS USED
-------------------------------------------------------- Chapter 2:1.2
The funds raised through the sale of FAC bonds were used to provide
four categories of assistance. The Treasury's commitment to advance
interest payments on the FAC bonds is currently treated as a fifth
assistance category. These categories are described further below.
Table 2.2 shows the amounts of the five assistance categories and the
approximate dates on which each must be repaid. It also illustrates
that the 6.81-percent effective cost to the System of this assistance
is less than the 9.24-percent cost of the FAC debt issued to fund it.
Expressed in dollars, this difference is the estimated $229 million
to $264 million benefit to the System associated with the Treasury
interest advances.
Table 2.2
Effective Cost to System Banks of 1987
Act Assistance
Effectiv
e Principal
cost amount
(percent (in Repayment
Assistance category )\a millions) date
-------------------- -------- ---------- -- ------------
CPA payables 9.42 $417 July 2003
to
April 2004
Assistance preferred 6.22 419 July 2003
stock to
September
2005
Jackson FLB 4.71\b 388 July 2003
liquidation to
June 2005
Other uses 6.15 37 July 2003
============================================================
Wtd. avg./Total 6.81 $1,261
Treasury interest N/A $229- September
advances 264\c 2005
------------------------------------------------------------
\a These costs were calculated based on the mid-point of the
discounted cash flow yields for the various categories, including the
FAC projected and maximum Treasury interest advances. In 1991, FAC
estimated the actual amount advanced by the Treasury would be $444
million. The maximum amount the Treasury could have to advance is
$580 million.
\b This figure is based on the System's cost net of our projections
of FCSIC's estimated liability for repaying, at its maturity, much of
the principal portion of the FAC debt issued to fund the Jackson FLB
liquidation.
\c The $229 million to $264 million range shown in the table is based
on the FAC projected Treasury interest advances and the maximum
advances. These figures equal the net present values of the cash
flows among the Treasury, FAC, and System banks, discounted at the
rates on the underlying FAC bonds. The estimated cost to taxpayers
of $209 million to $243 million is the net present value of these
same cash flows discounted at a current market rate of 7 percent.
Source: GAO.
The first assistance category involves proceeds from the July 1988
and April 1989 sales of FAC bonds. Most of these funds were used to
make payments of $417 million that the healthier System banks would
otherwise have had to make to weaker banks under their capital
preservation agreement (CPA) for the third quarter of 1986 (CPA
payables).
The second assistance category concerns direct assistance to
particular System banks. Between November 1988 and September 1990,
with the approval of the Assistance Board, FAC sold more bonds and
raised additional funds to purchase a total of $419 million of
assistance preferred stock in the FCBs of Louisville, Omaha, St.
Paul, and Spokane. Buying the stock was the mechanism used for
funneling assistance to these banks.\1
The third assistance category also concerns a particular System bank.
The Assistance Board asked FCA to place the Jackson FLB in
receivership, and FCA did so in May 1988. FAC issued a total of $388
million in debt to liquidate this bank, again providing funds through
the mechanism of buying assistance preferred stock in it. Most of
the FAC debt for the Jackson FLB liquidation was issued in June 1990.
As discussed later in this chapter, FCSIC has assumed responsibility
for repaying the principal portion of this debt at maturity.
Meanwhile, the Treasury and the System will continue to pay interest
on it.
The fourth assistance category, Other uses, is relatively small. It
consists of the remaining $37 million of FAC debt proceeds. This
money was used for other purposes permitted by the 1987 act, such as
paying the operating expenses of the Assistance Board.
The fifth and last assistance category is the Treasury interest
advances. On all FAC debt except that issued to fund the CPA
payables, the Treasury must advance all interest due during the first
5 years that the bonds are outstanding. The Treasury must also pay
up to 50 percent of the interest on these bonds during the second 5
years, and System banks must pay the remainder. During the last 5
years, System banks must pay all interest when due. In 1991, FAC
estimated that the Treasury interest advances will total $444
million, but they might be as much as $580 million.\2 When the last
FAC bond matures in 2005, FAC must reimburse the Treasury for these
advances, using funds collected from System banks. As shown in table
2.2, the $229 million to $264 million benefit associated with the
advances reduces the effective cost of assistance to System banks.
For the reasons discussed earlier, this benefit to the System
involves an economic cost to taxpayers that we estimate at about $209
million to $243 million.
--------------------
\1 To get Assistance Board certification to receive assistance, these
four FCBs agreed to significant operating changes and reporting
requirements. The terms of these agreements regarding loan pricing
are discussed further in chapter 3.
\2 System banks are paying all of the interest on the $417 million in
FAC debt issued to fund the CPA payables. The Treasury is advancing
interest payments on the other $844 million in FAC debt. During the
second 5 years these bonds are outstanding, the Treasury share of the
interest payments will drop and the System's share will increase by
10 percent for each 1 percent that the unallocated surplus of the
System as a whole exceeds 5 percent of assets. We calculated that on
December 31, 1992, unallocated surplus was equal to 6.1 percent of
the System's reported total assets.
WHO MUST REPAY ASSISTANCE
-------------------------------------------------------- Chapter 2:1.3
FAC makes the principal and interest payments to the investors who
hold FAC bonds by collecting the necessary funds from System banks,
the Treasury, or FCSIC.\3 Figure 2.1 shows which organizations are
responsible for providing these funds. It also notes that System
banks will provide funds to FAC so that it can reimburse the Treasury
for the interest payments it must make during the first 10 years most
FAC bonds are outstanding.
Figure 2.1: Organization
Responsibilities for Repayment
of FAC Debt for Assistance
(See figure in printed
edition.)
\a Treasury's share of interest payments in the second 5 years could
be up to, but not exceed, 50 percent.
\b The System's share of interest payments in the second 5 years is
set at 50 percent. This percentage can increase based on a formula
using the System's amount of unallocated surplus to its assets.
\c FCSIC must provide funds to repay the principal amount of these
FAC bonds if the assisted FCBs do not do so.
Source: Prepared by GAO.
The 1987 act structured assistance so that System banks and
associations were not required to book any significant liabilities.
However, since FAC's accounts are included in the System's combined
financial statements, FAC debt appears as a liability on the balance
sheet prepared for the System as a whole.
The System's combined financial statements currently show a liability
for the full face amount of FAC debt,\4 without adjusting for the
more than $200 million of economic benefit associated with the
Treasury interest advances. In our view, it would have been more
appropriate and meaningful for the System to report an increase in
capital for this benefit when it was initially granted. We believe
FAC (and System banks) should still make this accounting
adjustment.\5
--------------------
\3 Under the 1987 act, System associations were required to help
repay the Other use assistance and Treasury interest advances. The
1992 act gives the FCBs responsibility for all of their related
associations' assistance repayment obligations.
\4 FAC debt was sold to investors at a price slightly below 100
percent of the face amount of the bonds to adjust for the difference
in the bonds' stated interest rates and market interest rates at the
moment of issuance. Therefore, the System's balance sheet actually
shows slightly less than the full face amount of FAC debt.
\5 As discussed in Accounting Principles Bulletin (APB) No. 21,
Interest on Receivables and Payables, when debt is issued on market
terms, the face amount is equivalent to the present value of future
interest payments plus the present value of the principal to be
repaid at maturity. FAC debt was not issued on market terms, from
the System's point of view, because the Treasury interest advances on
certain FAC bonds provide an economic benefit to FAC, which is passed
through to System banks. Therefore, in accordance with APB No. 21,
FAC should have recorded a liability for less than the full face
amount of these FAC bonds by establishing a related discount and
accreting it over time.
MECHANISMS FOR ASSISTANCE
REPAYMENT
---------------------------------------------------------- Chapter 2:2
Under the 1987 act, there was no formal mechanism for System banks to
accumulate funds for assistance repayment and neither the public nor
FCA could easily chart their progress toward financial recovery.
Acknowledging that the framework of the 1987 act left many
significant accounting and regulatory issues undefined, the System
banks formed a work group in early 1991 to develop an assistance
repayment plan and took some steps toward implementing it at the end
of that year. In addition, during 1992, two of the four assisted
FCBs redeemed their assistance preferred stock early.
The 1992 act incorporates the System's assistance repayment plan with
some minor modifications. It expands FAC's role in assistance
repayment. FAC must begin to collect and invest annual assessments
from System banks to accumulate funds for the eventual repayment of
the CPA payables assistance and the Treasury interest advances. The
1992 act also contains provisions regarding assistance preferred
stock. We describe the mechanisms for repayment of each category of
assistance in this section. These mechanisms continue to provide
accounting and regulatory relief to System banks.
CPA PAYABLES
-------------------------------------------------------- Chapter 2:2.1
System banks must pay all principal and interest on the FAC bonds
issued for the CPA payables, just as they do on the debt securities
they issue in the normal course of business.\6
However, in a departure from GAAP, the law states that the FAC debt
issued for the CPA payables cannot be reported as a liability of any
System bank. As discussed in more detail later, the System
calculates the unrecorded liability based on only the principal
amount due at maturity, resulting in a lower figure for each bank's
share of the debt than we used in our analysis.
The 1992 act required System banks to enter into agreements to make
annual payments to FAC, beginning no later than December 31, 1992,
toward the eventual retirement of the debt issued for the CPA
payables.\7 These annuity-type payments, plus the interest FAC earns
on investing them, are designed to accumulate to 90 percent of the
principal amount of the underlying FAC debt by the time it matures in
2003 and 2004. The banks must then pay the remainder. These
payments will reduce the banks' unrecorded liabilities for the CPA
payables over time. However, the banks may reschedule their payments
if making them would reduce their capital below the regulatory
minimum. The 1992 act does not limit the number of times payments
can be rescheduled.
--------------------
\6 The banks share in these payments pro-rata based on the size of
their (and their associations') portfolios of accruing "retail" loans
to farmers. This avoids double-counting for the "wholesale" loans
the FCBs make to the associations that lend directly to farmers.
\7 The three BCs have had such agreements in place and have been
making these payments to FAC since 1990. The Texas FCB began to set
funds aside during 1991 in anticipation of doing so. The Spokane FCB
was not required to begin making these payments to FAC until December
31, 1993.
ASSISTANCE PREFERRED STOCK
-------------------------------------------------------- Chapter 2:2.2
The law contemplates that the FCBs that received direct aid in the
form of assistance preferred stock will provide funds to repay the
underlying FAC debt when due by redeeming the stock. It also gives
these banks the option not to redeem the stock at that time or to
redeem it early.\8 Because of these provisions, recording the
assistance as capital rather than as a liability of the assisted FCBs
(and the Jackson FLB) can be justified under GAAP. However, GAAP
allows for a different treatment than these banks currently use that
more clearly reflects the economic substance of this direct aid,
while still allowing them to treat all of it as capital.\9 We believe
this alternative treatment also better reflects the benefits and
costs of early redemption of assistance preferred stock.
During 1992, two of the four assisted FCBs received Assistance Board,
FCA, and Treasury approval to arrange with FAC to redeem their
assistance preferred stock early. In September 1992, at a cost of
$47.7 million, the Omaha FCB purchased Treasury zero-coupon
securities that will fully cover the $107.2 million in FAC debt
underlying the bank's stock when it matures in 2003. The Omaha FCB
recorded the $59.5 million difference as surplus. The bank
transferred the Treasury zero-coupon securities to FAC, which placed
them in a trust. The underlying FAC debt remains outstanding, and
the Treasury continues to advance interest on it. AgriBank, which
was created from the merger of the St. Paul and St. Louis FCBs in
May 1992, completed a similar transaction in December 1992. AgriBank
had $133.4 million in assistance preferred stock outstanding before
the transaction in which it transferred securities worth $59.4
million to FAC and recorded $74 million as surplus.
The Omaha FCB and AgriBank together redeemed about $240 million, or
about one-half of the total of this assistance category, and recorded
about $134 million as surplus. By redeeming their assistance
preferred stock early, these two banks, in effect, realized the
economic benefit of not having to pay dividends on this stock at
market rates.
The 1992 act requires assisted FCBs to set aside earnings in special
"appropriated unallocated surplus" accounts so that they will be able
to redeem assistance preferred stock when the underlying FAC debt
matures.\10 The appropriated surplus remains "at risk" and can be
used to absorb future losses, but only after the other retained
earnings of the assisted FCBs are exhausted.
--------------------
\8 Before an assisted FCB redeems its stock, the law requires FCA, in
consultation with the Treasury, to certify that the FCB will remain
viable after it does so. An assisted FCB that is so certified can
still choose not to redeem the stock. If it does not or cannot
redeem the stock before the underlying FAC debt matures, the law
requires that it pay what is, in effect, a punitive dividend rate.
Until that time, the law characterizes the stock as paying no
dividends.
\9 As discussed in Securities and Exchange Commission Staff
Accounting Bulletins (SAB) Nos. 64 and 68, redeemable preferred
stock that is not issued on market terms should be booked at its fair
market value. That is, the book value of such stock should be
adjusted by the difference in a market dividend rate and the actual
dividend rate. This difference is then recorded as part of surplus
or retained earnings, or as paid-in capital.
\10 The assisted FCBs (except the Spokane FCB) began to use the 1992
act formula at year-end 1991. Under the 1992 act, the assisted FCBs
must target annual set asides equal to the greater of (1)
one-fifteenth of the assistance preferred stock or (2) one-third to
one-half of earnings as called for in their agreements with the
Assistance Board.
JACKSON FLB LIQUIDATION
-------------------------------------------------------- Chapter 2:2.3
Because the Jackson FLB is in receivership and will not redeem its
assistance preferred stock, FCSIC will repay the principal portion of
the underlying FAC debt at maturity. This arrangement parallels the
default provisions on assistance preferred stock specified by law.
It is spelled out in a contract among FAC, FCSIC, and other
interested parties signed in April 1990. FCSIC will meet this
obligation by first using all amounts available in the FAC Trust
Fund, then tapping its Insurance Fund. We project that FCSIC will
have to use at least $250 million from the Insurance Fund in the
years 2003 and 2005 as a result of the Jackson FLB liquidation.\11
--------------------
\11 The FAC Trust Fund contains the proceeds of the sale of
nonredeemable FAC stock to healthy System institutions required under
the 1987 act, less the amounts refunded to them in accordance with
1988 and 1989 amendments to the law. The FAC Trust Fund is to be
used to cover defaults on assistance obligations. With a December
31, 1992, balance of about $73 million, it will grow to about $136
million in 2005 assuming it is invested at 5-percent interest and no
further defaults on assistance occur. This would leave FCSIC to
cover about $252 million of the $388 million cost of liquidating the
Jackson FLB when the FAC debt underlying the assistance preferred
stock it issued matures between 2003 and 2005.
OTHER USES
-------------------------------------------------------- Chapter 2:2.4
System banks must repay the relatively small amount of Other uses
assistance when due early in the next century. Each bank already
records a liability for its share of the principal portion of this
obligation on its balance sheet. As discussed later, we believe the
banks should record liabilities for both the principal and the
interest portions of the Other uses assistance. Under the 1992 act,
the FCBs must assume responsibility for their related associations'
shares of this obligation as for all other assistance categories.
TREASURY INTEREST ADVANCES
-------------------------------------------------------- Chapter 2:2.5
The 1987 act empowered FCA, in consultation with the Treasury, to
decide how to handle repayment of the Treasury interest advances once
the principal amount of the FAC debt had been paid off, requiring
only that System institutions share the cost "on a fair and equitable
basis." Because of the difficulty of making a reasonable estimate of
how much each of them would ultimately have to repay, System banks
and associations did not record any liabilities for the Treasury
interest advances. While this decision may have been justifiable
under GAAP, it did not result in a meaningful accounting for these
obligations.
Recognizing this, System banks and associations, with FCA's
concurrence, began to record liabilities for the Treasury interest
advances at year-end 1991. However, they recorded liabilities only
for the advances that had been made so far, not the estimated total.
As discussed in more detail later, we do not believe the Treasury
interest advances should be presented as a separate category of
assistance. Instead, the economic benefit associated with these
advances should be reflected in the accounting entries for other
assistance categories.
Under the 1992 act, the banks must make annual annuity-type payments
to FAC, beginning on or about December 31, 1992, toward the eventual
repayment of the Treasury interest advances.\12
These payments will offset the banks' recorded liabilities over time,
but the 1992 act also permits System banks to ignore the impact of
these transactions on their regulatory capital ratios until the year
2000.\13 In effect, this allows both assisted and nonassisted banks
to count their shares of the $444 million to $580 million face amount
of Treasury interest advances as regulatory capital.
--------------------
\12 Initially, FAC will calculate the banks' payments based on its
estimate of the total amount of interest the Treasury will advance.
The exact total of the Treasury interest advances will not be known
before the year 2000. Until that time, the 1992 act establishes a
range for the size of the banks' annual payments. They must be equal
to between 4 and 6 basis points of the banks' (and their related
associations') loan volume. After the year 2000, FAC can adjust the
payments up or down depending on the actual amount of the Treasury
interest advances and on how much it has already collected from the
banks. The Spokane FCB is not obligated to begin making these
payments to FAC until December 31, 1993.
\13 In 2000 and 2001, the banks can continue to count 60 percent and
30 percent of the Treasury interest advances, respectively, as
regulatory capital. By 2002, when they must fully acknowledge the
impact of the related liabilities on their balance sheets in
calculating their regulatory capital ratios, the annuity-type
payments will likely have offset most or all of these liabilities.
WEAKNESSES IN ASSISTANCE
REPAYMENT MECHANISMS
---------------------------------------------------------- Chapter 2:3
By specifying mechanisms for System banks to accumulate funds to meet
their assistance repayment obligations, the 1992 act addresses one
weakness of the 1987 act. As described above, the 1992 act sets
forth schedules for amounts to be set aside to repay three large
categories of assistance. This will provide some discipline to
System banks in planning for their repayment. The 1992 act
mechanisms also provide assurance to interested parties, including
the System banks themselves, that funds for repayment will be readily
available when needed. However, the new law still provides both
accounting and regulatory relief to the banks. They can continue to
avoid recording the real costs of assistance now and can continue to
count it as permanent capital for regulatory purposes.
We think this relief is inappropriate and unnecessary. We strongly
supported the reforms of the mid-1980s that were designed to put the
System on a solid basis of financial accounting so that its
member-borrowers, investors, and the government would know the true
financial condition of System institutions.\14 We do not believe the
new law goes far enough to achieve this objective. Although the 1992
act mechanisms will reduce the overstatement of System banks' capital
positions in time, the public and FCA do not currently have
completely accurate information on their financial condition.
Similarly, as we recently reaffirmed in our 1991 report on GSE
regulation,\15 we believe FCA should be able to exercise the full
range of powers granted to it as an independent, arm's-length
regulator of the System in 1985. Among the key authorities we
believe a regulator should have is the ability to set minimum capital
requirements. The elements of regulatory capital should include only
those items that protect the government's financial interests.
Assistance preferred stock, for example, does not meet this criterion
since FCSIC and the Treasury are exposed to risk of loss on this
investment should System banks be unable to repay it. Another key
authority a regulator should have is the ability to act in a timely
manner to ensure compliance with these regulations through a clear,
fair, and reasonable process. Following these principles would help
ensure that System banks meet their assistance repayment obligations
while operating in a safe and sound manner. Again, in our view, the
1992 act falls short of this goal.
System banks have agreed to CIPA standards that more clearly
recognize the impact of assistance repayment obligations on their
capital positions. However, we believe it would be unwise to rely on
CIPA as a substitute for federal regulation. CIPA is an arrangement
between the banks that they can and probably will modify from time to
time. The banks did not successfully deal with the financial stress
of the mid-1980s through the Capital Corporation or other interbank
arrangements. It was this failure that led to the need for federal
assistance and intervention in the first place.
In this section, we first discuss the System's analysis of the
effects of the 1992 act provisions regarding assistance and present
our analysis of the banks' financial statements as of December 31,
1992. Our analysis shows that eliminating the accounting and
regulatory relief is feasible. It demonstrates that all System banks
can now meet minimum regulatory capital standards under our
recommendations. We then review several regulatory relief provisions
of the 1992 act that we believe should be reconsidered.
--------------------
\14 See Farm Credit: Actions Needed on Major Management Issues
(GAO/GGD-87-51, Apr. 1, 1987).
\15 See Government-Sponsored Enterprises: A Framework for Limiting
the Government's Exposure to Risks (GAO/GGD-91-90, May 22, 1991).
ELIMINATING ACCOUNTING AND
REGULATORY RELIEF IS
FEASIBLE
-------------------------------------------------------- Chapter 2:3.1
As part of the development of its new repayment plan, which was
incorporated in the 1992 act, the System work group requested that
each bank project its financial condition and performance through the
year 2005 when the last of the assistance must be repaid. The work
group then analyzed the impact of the plan on the banks' regulatory
capital ratios. This analysis showed that several System banks would
have regulatory capital ratios near 20 percent over many years; one
assisted FCB attained a ratio of over 50 percent by the time its
assistance had to be repaid. These ratios are well in excess of
FCA's 7-percent minimum and are due in part to projected real
improvements in the banks' capital positions. However, some of this
apparent improvement is explained by accounting and regulatory
relief. We independently performed an analysis similar to that of
the System work group. Using more conservative assumptions about
growth in System loan volume and earnings distributions, we reached
the same general conclusion that the work group did. We found that
all System banks could meet and many could substantially exceed the
minimum regulatory capital requirement.\16
We also analyzed how our proposals for improving the regulatory and
accounting treatment of assistance repayment obligations would have
affected System banks as of December 31, 1992. To do this, we
adjusted the banks' published financial statements and the regulatory
capital ratios they reported to FCA based on what we believe to be a
more realistic accounting treatment of their assistance obligations.
First, we assumed that System banks directly acknowledged the
self-help aspects of the 1987 act assistance program by recording
liabilities to FAC related to all banks' shares of the dividends on
assistance preferred stock at the below-market rates that represent
the effective cost of this capital. Second, we adjusted the
regulatory capital ratios of the assisted FCBs to avoid counting both
the face amount of the assistance preferred stock and the amounts
contained in related surplus accounts as regulatory capital.
Finally, we credited all System banks for the amounts they have so
far deposited with FAC toward repayment of the Treasury interest
advances and the CPA payables assistance. We then computed new
regulatory capital ratios for all banks.
Our results, presented in table 2.3, show that all banks would have
been able to meet FCA's final 7-percent minimum regulatory capital
requirement that took effect on January 1, 1993. These results
illustrate that putting System banks on a sound basis of financial
accounting for assistance obligations would not subject any of them
to serious financial stress.
Table 2.3
Regulatory Capital Ratios of System
Banks Before and After Eliminating
Accounting and Regulatory Relief as of
December 31, 1992
(In percent)
Report
Bank ed Adjusted
--------------------------------------- ------ -----------
Springfield FCB 9.4 7.2
Baltimore FCB 13.5 8.3
Columbia FCB 19.7 16.8
Louisville FCB 14.7 11.7
Jackson FICB 14.5 13.7
AgriBank 9.3 8.3
Omaha FCB 10.1 8.6
Wichita FCB 14.6 13.1
Texas FCB 15.6 13.6
Western FCB 10.9 8.9
Spokane FCB 9.9 8.2
Springfield BC 9.7 9.4
St. Paul BC 10.1 9.0
CoBank 9.7 8.2
------------------------------------------------------------
Source: Prepared by GAO.
--------------------
\16 We must emphasize that we did not attempt to predict the actual
performance of the System over the next 15 years. Neither our
analysis nor the banks' projections takes the possibility of another
1980s-style financial crisis in agriculture into account. Our
analysis also did not take other unpredictable events, such as last
year's midwestern floods, into account. Such adverse conditions
could, of course, impair the ability of System banks to meet their
assistance repayment obligations.
CHANGES NEEDED IN SYSTEM
ACCOUNTING TREATMENT FOR
ASSISTANCE
-------------------------------------------------------- Chapter 2:3.2
Currently, System banks account for most payments they are required
to make to FAC as if each were a separate, noninterest-bearing
obligation that was unrelated to how assistance was used. GAAP
requires recording noninterest-bearing liabilities at their present
values and is flexible enough to justify treating transactions
between related parties, such as System banks and FAC, according to
their legal forms.\17 The System's treatment relies on the fact that
the law does not specifically characterize the FAC debt issued to
fund the CPA payables assistance as a direct obligation of the banks
and separately discusses the banks' responsibilities for the
principal payments and the interest payments on the FAC debt issued
for Other uses. System officials also concluded that only the
Treasury interest advances made to date needed to be recorded as
liabilities by the banks and FAC. This accounting treatment does not
recognize that the Treasury, FAC, and System banks have well-defined
future legal rights and obligations to each other related to these
advances. The treatment we suggest recognizes these rights and
obligations.
We believe the treatment we suggest is more appropriate because it
better reflects the economic substance of the 1987 act assistance.
Some of the assistance is clearly a loan from FAC. Therefore, we
believe System banks should record it as a liability in the usual
way. As noted earlier, all banks are required to pay both the
principal and the interest on the FAC debt underlying the CPA
payables assistance when due, just as they are on the debt securities
they issue in the normal course of business. In our view, this loan
from FAC should not be treated differently. System banks should
record it as a liability at its face amount. The same is true of the
other use assistance, except that the Treasury is currently advancing
interest on these FAC bonds. Therefore, System banks should record
this liability at less than its face amount to reflect the economic
benefit of these advances.\18
The preferred stock issued by the assisted FCBs and the Jackson FLB
should reflect the accounting treatment discussed earlier regarding
the benefits associated with this stock. They and other System banks
also have related obligations that need to be accounted for: they
must supply FAC with funds to make interest payments on the debt
issued to fund the original stock purchase. We adjusted all banks'
balance sheets to reflect these liabilities to FAC.
In summary, the System's accounting treatment for most categories of
assistance may be in accord with a legal form and as a result may
arguably be a justifiable alternative under GAAP. However, in our
view, this treatment does not accurately reflect the economic
substance of the transactions and is therefore not the most
appropriate or meaningful GAAP alternative for the assistance the
banks received under the 1987 act.
--------------------
\17 In 1991, we recommended that GAAP be clarified to require such
transactions to be accounted for based on their economic substance.
See Failed Banks: Accounting and Auditing Reforms Urgently Needed
(GAO/AFMD-91-43, Apr. 22, 1991), pp. 32-33.
\18 To do this, System banks should follow APB No. 21, the
accounting guidance discussed in footnote 5 of this chapter.
CHANGES NEEDED IN REGULATORY
CAPITAL PROVISIONS OF THE
1992 ACT
-------------------------------------------------------- Chapter 2:3.3
As noted earlier, the 1992 act maintains the regulatory relief
granted under the 1987 act, permitting System banks to continue to
disregard most of the costs of assistance and to count it as
permanent regulatory capital over a long period. We believe
continuing this relief is inappropriate because, from the point of
view of protecting the government's financial interests, the federal
assistance granted under the 1987 act is a temporary form of capital.
CPA PAYABLES AND TREASURY
INTEREST ADVANCES
PROVISIONS DO NOT CORRECT
REGULATORY CAPITAL
DISTORTIONS
------------------------------------------------------ Chapter 2:3.3.1
Under the 1992 act, System banks can reschedule their annuity
payments to FAC for the CPA payables apparently without limit if
making these payments reduces their capital below the regulatory
minimum. Thus, a weak bank could, in principle, both avoid
regulatory sanctions and postpone these payments until 2003 and 2004
when the underlying FAC debt is due. Such a bank would then face a
large liability and reduction in capital. Delaying regulatory
intervention in cases like these would, we believe, be
counterproductive.
Another problem concerns the payments and liabilities for the
Treasury interest advances. As mentioned earlier, the 1992 act
allows System banks to, in effect, count these advances as permanent
capital\19 for regulatory purposes until the year 2000. These
amounts, however, are not capital: they are shown as expenses (that
is, reductions in capital) in System banks' financial statements.
If System banks make their annual payments to FAC as scheduled for
the CPA payables and Treasury interest advances, the overstatement in
their capital positions will not increase and, after the year 2000,
will disappear. However, neither the public nor FCA will have
accurate, readily available information on System banks' financial
condition for the next several years. Also, since banks that are in
fact weak could appear to have adequate capital for some time to
come, FCA might not have sufficient regulatory basis for taking
prompt action to require them to correct their performance problems
or for enforcing changes if banks protest. For those reasons, we
believe that these provisions of the 1992 act are imprudent and
should be reevaluated. System banks, in their CIPA program, imposed
stricter standards for these categories. Their CIPA program
increases the capital standards banks must meet to compensate for
these liabilities posing as capital.
--------------------
\19 Permanent capital for most financial institutions is defined by
regulation, rather than by statute. The definition of permanent
capital for System institutions is set out in section 4.3A(a) of the
Farm Credit Act.
ASSISTANCE PREFERRED
STOCK PROVISIONS RESULT
IN SERIOUS DISTORTION OF
REGULATORY CAPITAL
------------------------------------------------------ Chapter 2:3.3.2
The law does not permit FCA to acknowledge that the assistance
preferred stock is, from the point of view of protecting the
government's financial interests, a temporary form of capital. Until
they redeem it, the assisted FCBs can continue to report the stock as
capital on their balance sheets, along with disclosures as to its
terms and conditions. However, we believe the amount of assistance
preferred stock that counts as regulatory capital should be reduced
to zero as the maturity date of the underlying FAC debt approaches.
Otherwise, a serious distortion in the remaining assisted FCBs'
regulatory capital positions will develop over time. The reason for
this is that both the face amount of assistance preferred stock and
the funds set aside to repay it under the 1992 act mechanisms
described above count as regulatory capital.
We believe the law should be amended so that FCA has the authority to
address this. The System banks, in designing their CIPA program,
agreed that counting both the face amount of assistance preferred
stock and the appropriated surplus set aside to repay it was an
inappropriate way to measure progress toward achieving higher levels
of financial condition and performance. In calculating compliance
with CIPA, the capital of the assisted FCBs is reduced by a fixed
amount each year to eliminate the double-counting.
FCSIC ISSUES
---------------------------------------------------------- Chapter 2:4
FCSIC became fully operational on January 1, 1993, when the
Assistance Board sunset. On December 31, 1992, it reported total
assets of $656 million. Besides its initial capital of $260 million,
FCSIC had collected or accrued about $400 million in insurance
premiums and investment income. As discussed earlier, FCSIC will
take responsibility for repaying the $388 million in FAC debt issued
to liquidate the Jackson FLB when this debt matures. This is FCSIC's
only significant liability. On December 31, 1992, the estimated
present value of this obligation was $166 million.\20 This left the
Insurance Fund with a net balance of $488 million.
--------------------
\20 Under APB No. 21, which is discussed in more detail in footnote
5 of this chapter, it is appropriate for FCSIC to record a liability
for the present value of the FAC debt issued to fund the purchase of
assistance preferred stock in the Jackson FLB, since FCSIC is
responsible for repaying only the principal portion of this debt.
SYSTEM SHOULD REPAY $260
MILLION TRANSFERRED TO FCSIC
-------------------------------------------------------- Chapter 2:4.1
FCSIC's initial capital came from the transfer, in 1989, of $260
million from FCA revolving funds originally set up to provide
start-up capital to new System institutions. As discussed in chapter
1, after all System institutions had repaid the federal government
for the funds used as start-up capital, the revolving fund remained
available to FCA to meet emergencies. The 1987 act authorized the
transfer of the revolving fund to the Insurance Fund but, unlike all
previous taxpayer money provided to the System, the law does not
require repayment of this amount.
We believe that Congress should require FCSIC to return this initial
capital infusion of $260 million to the Treasury. Our analysis shows
that FCSIC could make up the difference by collecting premiums from
System banks for about 3 years longer than currently anticipated. We
have stated a strong preference for financing federal insurance funds
from industry sources. In fact, we believe that industry should bear
this burden unless doing so would irreparably harm healthy
institutions.\21
Congress employed this principle with previous industry-financed
insurance funds in the 1950s and in the most recent reform of
commercial bank deposit insurance--the Federal Deposit Insurance
Corporation Improvement Act of 1991 (P.L. 102-242, 105 Stat. 2236).
That legislation provided increased borrowing authority, not an
appropriation, to the Bank Insurance Fund. Any such loans from the
Treasury must be repaid through additional premiums paid by insured
commercial banks, preserving the industry-financed nature of federal
deposit insurance. Another reason to return the $260 million is that
this transfer without repayment is a departure from the overall
policy of the 1987 act that the System repay federal assistance.
--------------------
\21 See Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26,
Mar. 4, 1991).
REPAYMENT OF $260 MILLION IS
FEASIBLE
-------------------------------------------------------- Chapter 2:4.2
To test the feasibility of returning FCSIC's initial capital
infusion, we projected the impact this would have on the Insurance
Fund. We did this by calculating the present and future fund balance
assuming that the entire $260 million had been returned to the
Treasury's general fund on January 1, 1993, when FCSIC became fully
operational. We chose a lump sum payment on this date to illustrate
the effect of immediate repayment. If the money were returned later,
or in a series of payments over time, the impact on FCSIC would, of
course, be lessened. The projection used several simplifying
assumptions, the most important being that FCSIC would not be called
on to pay any claims other than for the Jackson FLB.\22 We considered
several scenarios using different growth rates for System loan volume
and rates of interest on FCSIC investments in Treasury securities for
compounding the fund balance. We started with FCSIC's financial
statements as of June 30, 1992, when the balance of the Insurance
Fund was $440 million.
If System loan volume remains constant, and FCSIC earns 5 percent on
investments, we project the Insurance Fund will reach its secure base
in the second quarter of 1998. If FCSIC had returned $260 million to
the Treasury on January 1, 1993, we project that the secure base
would be reached 3 years later in the second quarter of 2001. Under
this scenario, the balance in the Insurance Fund would have fallen to
about $245 million on January 1, 1993. However, since FCSIC is
taking in more than $100 million in premium and interest income
annually, the initial capital infusion would be replaced by 1996. We
believe the improving financial condition of System banks makes
further immediate large claims on the Insurance Fund unlikely.
Consequently, we believe FCSIC can return the $260 million to the
Treasury general fund within a reasonable period of time without
undue risk. Even if a large, unexpected claim on the Insurance Fund
is made in the near future, before the secure base amount is
attained, taxpayer money would not necessarily be required to meet
it. Instead, System banks could be called on to support each other
under the joint and several liability provisions of the Farm Credit
Act. As noted earlier, all System banks now meet or exceed
regulatory minimums for capital. On December 31, 1992, the combined
capital of all System banks was well over $4 billion.
--------------------
\22 The simplifying assumptions we adopted are similar to those FCA
used to assess the impact of the Jackson FLB receivership on FCSIC.
For example, we ignored FCSIC's operating costs. We also ignored the
differential insurance premiums on certain categories of System loans
since these are relatively small and difficult to quantify.
FCSIC'S INSURANCE FUND
SHOULD BE REMOVED FROM
SYSTEM'S BALANCE SHEET
-------------------------------------------------------- Chapter 2:4.3
FCSIC is, in effect, treated as a System institution in the System's
combined financial statements even though it is an independent
federal entity. The premiums FCSIC collects from System banks are
"on-budget"--they are counted as income of the federal government.
Yet, in its financial statements, the System does not expense these
premiums, reports FCSIC's earnings on them as "other income" of the
System, and reports the Insurance Fund as a "restricted asset" and as
"restricted capital." As an OMB official emphasized to us, FCSIC's
income and assets are public, not private funds.\23 The Insurance
Fund, like its predecessor the revolving fund, was established by and
is maintained and controlled by the federal government, not by the
System. We do not believe it can be properly characterized as a form
of self-insurance as the System suggests. For this reason, among
others, we believe that the System should not combine FCSIC's
financial statements with its own or use any accounting treatment
that has this effect.
More importantly, while including the Insurance Fund in the System's
financial statements improves its combined earnings and capital now,
doing so also means the System as a whole is not well positioned to
derive the intended benefit from FCSIC assistance in the future. The
purpose of the Insurance Fund is to avoid a situation in which
problems at weak System banks (or associations) adversely affect the
operations of other banks or of the System as a whole. FCSIC is to
do this by providing replacement capital to improve troubled
institutions' condition or to cover defaults. However, unless the
System removes the Insurance Fund from its balance sheet, future
FCSIC assistance will not increase System capital for the simple
reason that, under the current treatment, FCSIC capital is already
part of System capital. Put another way, only if the Insurance Fund
is removed would FCSIC assistance increase the capital the System as
a whole could report to investors during future difficult times.
In July 1989, FCA issued an accounting bulletin that stated that
FCSIC premiums should be expensed on the System's combined financial
statements and that the Insurance Fund should not be included as a
restricted asset. The bulletin was set aside by a district court on
procedural grounds and FCA did not appeal the court's decision. FCA
officials indicated that FCA may promulgate regulations on this
matter. In December 1993, the System proposed, and FCA formally
accepted, a form of disclosure that lists the Insurance Fund
separately before combining it with other System accounts and
provides supplemental information.\24
This revised disclosure will appear in the notes to the System's
combined financial statements for the year ended December 31, 1993.
The FCA Board approved in December 1993 a proposed regulation on
disclosure to investors that incorporates the System's revised
disclosure for the Insurance Fund. According to FCA, because of
these actions, it no longer has a dispute with the System's
accounting treatment of the Insurance Fund.
We believe this issue still requires resolution because the System's
financial statements remain inconsistent with those FCSIC publishes,
even though both prepare GAAP-based financial statements audited by
independent public accountants. One problem is that both the System
and FCSIC claim the Insurance Fund as an asset. In addition, as
discussed further in the next section, the System and FCSIC do not
currently report the same balance for the Insurance Fund.
The recent agreement between FCA and the System concerning Insurance
Fund disclosure still inappropriately allows the combination of
System and FCSIC accounts. FCA noted in its July 1989 accounting
bulletin that since neither common control nor common management
exists between FCSIC and System institutions, FCSIC's accounts should
not be combined with the System's. Therefore, FCA concluded that
including the Insurance Fund on the System's combined balance sheet
is inconsistent with GAAP. On the other hand, the System argues that
since FCSIC's assets can only be used to benefit System institutions,
presenting the Insurance Fund as a restricted System asset and as
restricted System capital is the most appropriate (and indeed the
required) accounting treatment under GAAP. Both FCA and the System
have opinions from independent public accountants to support these
views. We concluded, based on our review of applicable accounting
guidance, that the exclusion of the Insurance Fund as System assets
and capital would result in a more appropriate presentation of the
System's financial condition. While we agree that the revised
disclosure is useful, we continue to believe that complete removal of
the Insurance Fund from System combined financial statements is the
better presentation. The basis for our conclusion is discussed in
detail in appendix I.
--------------------
\23 OMB classifies the Insurance Fund as a "public enterprise fund,"
the same budget classification applied to the account that contains
the assessments System institutions pay to cover FCA's operating
costs. Public enterprise funds are defined in the Budget of the
United States Government for Fiscal Year 1994 as "accounts for
business or market-oriented activities conducted primarily with the
public and financed by offsetting collections that are credited
directly to the fund."
\24 The System's proposed disclosure maintains that the assets and
related capital of the Insurance Fund are "restricted assets" and
"restricted capital." The proposed disclosure notes that the
Insurance Fund is under the direct control of FCSIC and not any
System institution. For the Insurance Fund, the proposed disclosure
specifies mandatory and discretionary uses, possible authorized forms
of expenditure by FCSIC, and estimated obligations. The proposed
disclosure also contains supplemental schedules to the basic combined
financial statements showing System accounts combined without the
Insurance Fund, then the Insurance Fund accounts separately, and
ultimately combining the System and Insurance Fund accounts.
EFFECTS OF REMOVING
INSURANCE FUND FROM SYSTEM
BALANCE SHEET
-------------------------------------------------------- Chapter 2:4.4
Removing the Insurance Fund from the System's balance sheet would
have no effect on the financial reports of any individual System bank
because it is only claimed on the System's combined statements. The
System's overall reported earnings for 1989 to 1992 would have been
significantly different, however, if the Insurance Fund had not been
treated as a System asset. Expensing the premiums System banks paid
to FCSIC and omitting FCSIC's investment income would have lowered
reported earnings for these years by about 11 to 15 percent. As of
December 31, 1992, removing the Insurance Fund would have reduced the
System's combined capital by $656 million. The adjustment related to
the Jackson FLB discussed below would partially offset this
reduction. Over time, the effect of removing the Insurance Fund from
the System's balance sheet will become more significant. It will
result in larger reductions in reported total capital the longer
action is delayed. Once the Insurance Fund reaches its secure base
amount, removing it would reduce the System's reported capital ratio
by about 2 percentage points.
Because of differences in accounting for the Jackson FLB's failure,
the System and FCSIC do not now report the same balance for the
Insurance Fund. Currently, the System reports FCSIC's total assets
as the Insurance Fund, rather than first subtracting FCSIC's
liability for the Jackson FLB liquidation as FCSIC itself does.
System officials justify this by noting that the System already
records the underlying FAC debt on its balance sheet. We are
concerned that labeling FCSIC's total assets as the Insurance Fund
may mislead investors, even though notes to the System's financial
statements disclose the facts of the Jackson FLB arrangement.
As noted earlier, System banks and FCSIC signed a contract in 1990
under which FCSIC has responsibility for repaying the FAC debt issued
to liquidate the Jackson FLB. Thus, we believe the System's combined
balance sheet should reflect FCSIC's commitment to pay off this debt.
FCSIC currently estimates this commitment to be $166 million. This
would eliminate the discrepancy between the figures the System and
FCSIC report as the Insurance Fund balance.
CONCLUSIONS
---------------------------------------------------------- Chapter 2:5
Because of the way the 1987 act structured the program of federal
assistance to the System, individual System banks were not required
to and have not recognized the full costs of the 1987 act assistance
package. By characterizing FCSIC's Insurance Fund as a form of
self-insurance, the System is not well positioned to realize the
intended benefit of future federal help should the need for it arise.
This is because the replacement capital available in the Insurance
Fund is, under the System's current accounting treatment, already
counted as part of the System's capital.
System banks have partially acknowledged their obligations relative
to the 1987 act assistance by supporting legislation that establishes
mechanisms for them to accumulate funds to repay the bulk of FAC
debt. In addition, two of the four assisted FCBs have already made
arrangements to repay most of the direct assistance they received.
Nevertheless, we believe further improvements can and should be made
in the accounting and regulatory treatment of the System's assistance
repayment obligations. Even though overstated, the financial
condition of System banks has greatly improved. Thus, the System can
make such changes now without doing significant damage to its
business or creating undue concern in the investor or borrower
communities. These changes would help give a true picture of the
System's financial health and ensure appropriate regulatory
oversight.
Our analysis also suggests that FCSIC can return $260 million in
taxpayer money transferred to it under the 1987 act within a
reasonable period of time without undue risk. We believe the System
should repay this amount; failure to do so would be inconsistent with
past practice and recent legislation reaffirming Congress' policy in
favor of industry financing of federal insurance by competing
financial institutions as well as a departure from the 1987 act's
overall policy that the System repay federal assistance.
We also believe it is inappropriate to include FCSIC's income and
assets in the financial statements prepared for the System as a
whole. We concluded that doing so overstates the System's current
earnings, assets, and capital. More importantly, if the System
continues its present accounting treatment for FCSIC premiums and the
Insurance Fund, it will not be able to record any increase in
earnings or capital in the event one or more System institutions
experience serious financial difficulty in the future. This, in
effect, deprives the System of the intended benefits of the statutory
mechanism to provide federal support in times of stress.
RECOMMENDATIONS
---------------------------------------------------------- Chapter 2:6
We recommend that Congress
require that System institutions record all categories of
assistance granted under the 1987 act using the GAAP that best
reflects the economic substance of this federal aid;
provide FCA statutory authority to recognize all categories of 1987
act assistance as temporary, not permanent, capital of System
banks for regulatory purposes; and
require FCSIC to reimburse the Treasury for its initial capital
infusion of $260 million within a reasonable time, taking the
financial condition of the System and the Insurance Fund into
consideration.
We also recommend that the FCA require the System to exclude FCSIC's
Insurance Fund from its combined financial statements.
LOAN PRICING AND COMPETITION AMONG
AGRICULTURAL LENDERS
============================================================ Chapter 3
After the System received federal financial assistance, some
competitors, notably small midwestern commercial banks, accused it of
engaging in below-cost predatory pricing and other unsafe or unfair
lending practices. They pointed out that, as permitted by law,
System banks did not record liabilities for all of their assistance
repayment obligations. This, they maintained, obscured System
institutions' true cost of doing business and whether System loan
rates were high enough to cover all costs. Our economic analysis and
review of FCA's oversight revealed little evidence of unfair or
unsafe loan pricing practices among System institutions. However,
the System's status as a GSE and a cooperative does give it cost
advantages over some other agricultural lenders. These advantages
also figure in the complaints of unfair competition against the
System.
In this chapter, we first discuss how System loan pricing practices
(and regulatory oversight of those practices) have changed since the
reforms of the mid-1980s. Second, we discuss how the System's cost
structure differs from that of large and small commercial banks and
insurance companies. Finally, we compare System loan rates with
those of these other lenders, both nationally and in selected
midwestern local markets.
THE ECONOMICS OF UNFAIR
COMPETITION
---------------------------------------------------------- Chapter 3:1
In March 1990, representatives of the Nebraska Bankers Association,
the Nebraska Independent Bankers Association, FCA officials, and the
president of the Omaha FCB testified before a House subcommittee on
the subject of predatory pricing by the System.\1 At issue was
whether the System's lending practices could be considered predatory
or just appropriately aggressive and competitive.
According to economic theory, a firm engages in predatory pricing
when it temporarily sets its prices below cost to eliminate or
discourage competitors and so gain a monopolistic or dominant market
position. The successful predator firm then charges higher prices
and earns higher profits over the long run. In recent years the
courts, including the U.S. Supreme Court, have aligned with
economists who believe that true cases of predatory pricing are rare.
In 1986 decisions, for example, the Supreme Court relied on economic
analyses suggesting that predatory pricing schemes are rarely tried
and even more rarely successful because of the low probability that a
firm could gain a monopoly for long enough to recoup its short-term
losses.\2 Other economists, however, believe that predatory pricing
can be a rational and profitable strategy under certain conditions.\3
One recent contribution to the economic literature notes that if a
competitor is a public rather than a private entity it may try to
maximize its size or output rather than its profit. Under these
circumstances, this study concludes, the public firm may set its
prices so low that competitors have to withdraw from the market.\4
Although the System is privately owned, as a GSE it is a quasi-public
organization. At the March 1990 hearing, the midwestern commercial
bankers emphasized this in their discussions of predatory pricing,
saying that aggressive competition from the System was hurting them.
They also questioned whether the System's loan pricing practices were
safe and sound. In the late 1970s and early 1980s when the System
was using average-cost pricing to build its market share and
regulatory oversight was lax, such criticism was certainly warranted.
In 1986 amendments to the Farm Credit Act, Congress addressed
problems with System loan pricing practices. It authorized the
System, rather than FCA, to set loan rates, opening the way for
System rates to become more market-oriented. The amended policy
section of the Farm Credit Act noted that farmers' credit needs are
best served if System institutions provide "equitable and
competitive" rates. The tension between equitable and competitive
helps explain some of the recent controversy over the System's loan
pricing practices.
Many System institutions still emphasize the equitable side and
strive to offer the lowest possible loan rates consistent with safe
and sound operations. This operating philosophy is based on the
cooperative tradition of "service at cost." It has the effect of
minimizing earnings and may contribute to perceptions of unfair
competition. Member-borrowers of these institutions usually receive
low or zero rates of return on their stock. Other System
institutions now emphasize the competitive side. They charge
essentially the same loan rates other lenders do, attempting to make
profits and pay high dividends on the stock their member-borrowers
own.
--------------------
\1 See Predatory Pricing Within the Farm Credit System, hearing
before the Subcommittee on Policy Research and Insurance of the
Committee on Banking, Finance and Urban Affairs, House of
Representatives, 101st Cong. 2d Sess. (1990).
\2 This is the view of the "Chicago School" of economics. See
Matsushita Electric Industry Co. v. Zenith Radio Corp., 475 U.S.
574, 589 (1986); Cargill Inc. v. Montfort of Colorado, Inc., 479
U.S. 104, 121 (1986).
\3 The work of many of these economists reflects insights gained
through the application of game theory in models in which the firms
have incomplete (asymmetrical) information. In some of these models,
predatory pricing pays off for firms that establish a reputation for
tough competition or falsely signal that they have a cost advantage,
thereby discouraging other firms from entering the industry. For
surveys of this literature, see Jonathan B. Baker, "Recent
Developments in Economics that Challenge Chicago School Views,"
Antitrust Law Journal, Vol. 58 (1989), pp. 645-655; and J.A.
Ordover and G. Saloner, "Predation, Monopolization, and Antitrust"
in Richard Schmalensee and Robert D. Willig, eds., Handbook of
Industrial Organization, Amsterdam, North-Holland, 1989, Vol. 1, pp.
545-562.
\4 See John R. Lott, Jr., "Predation by Public Enterprises," Journal
of Public Economics, Vol. 43, No. 2 (November 1990), pp. 237-251.
FCA AND THE ASSISTANCE BOARD
ENCOURAGED CHANGES IN SYSTEM
LOAN PRICING PRACTICES
---------------------------------------------------------- Chapter 3:2
FCA examiners review System institutions' policies and procedures for
making and pricing loans in annual examinations, criticizing any
questionable practices they observe. FCA enforcement actions have
required changes in loan pricing practices at some troubled FCBs and
associations. Between 1989 and 1991, FCA also responded to at least
39 complaints of unfair competition by System institutions. These
included 25 complaints citing specific instances of alleged predatory
pricing or other improper loan pricing practices. FCA confirmed none
of the allegations. In annual examinations not related to any
complaint, FCA concluded that one association was engaging in what
FCA defined as predatory pricing and took enforcement action against
the association in 1990.
The Assistance Board required the four assisted FCBs, sometimes with
the help of outside consultants, to improve their policies and
procedures for pricing loans. Assistance Board officials did not
believe any assisted FCB engaged in unsafe or unfair loan pricing
practices. They did acknowledge that some of these banks and their
related associations were competing aggressively for new business.
FCA EXAMINED LOAN PRICING
PRACTICES CAREFULLY,
IDENTIFIED PROBLEMS, AND
REQUIRED CORRECTIVE ACTION
-------------------------------------------------------- Chapter 3:2.1
FCA reviews the loan pricing practices of System institutions in
annual examinations. The loan pricing examination is based on the
guidance provided in FCA's Examination Manual. In various policy
statements, FCA defines predatory pricing as
"The practice of setting interest rates to attract or retain
borrowers with a willful disregard for the costs of doing
business, or well below prevailing rates in the market area due
to the failure to monitor competitor rates."
We believe this definition is not, as asserted by ABA, contrary to
applicable law.\5 FCA examiners use this guidance and their knowledge
of System institutions to assess if a particular institution's loan
pricing policy is consistent with its earnings goal and whether this
goal will enable the institution to meet regulatory capital
requirements. They then determine whether loans are actually being
priced in accordance with the policy. Examiners look for evidence
that the institution is aware of competitive market rates (for
example, that it surveys other agricultural lenders in its area) and
can show that they influence its pricing decisions. Examiners also
incorporate any allegations of improper loan pricing or underwriting
into plans for the institution's annual examination.
During the 1988 and 1989 examinations of some assisted FCBs,
examiners focused particular attention on loan pricing practices. At
one such bank, they assessed compliance with an FCA enforcement
action that required the bank to revise its policies and procedures
in this area. Examiners judged that the bank's new practices
complied with the enforcement action in 1991. FCA also criticized
some associations that now set rates on loans to farmers in many
areas of the country.\6 For example, one examination report urged an
association affiliated with an assisted FCB in the Midwest to adopt
higher profit targets on loans to reach its earnings and capital
goals more rapidly. However, FCA found no evidence of predatory
pricing at this association. We discuss two other examples in the
next section. A senior FCA official told us that, from a safety and
soundness perspective, not many associations are now pricing loans
inappropriately.
--------------------
\5 In comments on a draft of this report, ABA contends that the
policy section of the Farm Credit Act sets out the predatory pricing
standard of "below competitive market rates" to be used by FCA. ABA
asserts that this is the proper legal standard rather than the
standard of "well below prevailing rates" used by FCA in
investigating predatory pricing complaints. The legislative history
of the policy section indicates that Congress did not intend to
dictate a specific predatory pricing standard to FCA. Rather than
addressing interest rates within the context of predatory pricing,
the statute was intended to address concerns over possible
dissipation of System capital and earnings due to System
institutions' charging interest rates below competitive market rates.
The legislative history also shows that Congress did not intend to
constrain FCA's regulatory authority over System loan pricing
practices to the literal terms of the policy statement, but rather to
invest FCA with substantial discretion to oversee these practices in
the context of ensuring the System's safety and soundness and capital
adequacy.
\6 Some FCBs essentially control the rates on the retail loans
associations make by setting minimums or targets. Several FCBs limit
the types of retail loans the associations in their territories can
offer.
FCA FOUND ONLY ONE CASE OF
PREDATORY PRICING
-------------------------------------------------------- Chapter 3:2.2
Between 1989 and 1991, FCA responded to at least 39 inquiries about
unfair competition by System institutions. Almost all of the
inquiries (33 out of the 39) were made by or on behalf of small
commercial banks in the Midwest. Twenty-five complaints cited
specific instances of alleged predatory pricing or gave examples of
questionable loan pricing or underwriting practices. Many small
bankers said System institutions were offering low or favorable rates
to the most desirable customers (or only to new borrowers), which
they could not match and make a profit.
FCA found that no System institution had acted improperly in making
or pricing any of the loans cited in these complaints. FCA conducted
detailed investigations of 12 of the 25 specific cases.\7 The FCA
examiners looked at whether the loan in question was priced below
some measure of the institution's cost and whether it was made in
accordance with approved policies. In some cases, examiners
discussed the terms of the loan with System loan officers and
reviewed documentation on the loan's profitability. In other cases,
they compared the loan rate with the System institution's cost of
funds. These investigations, in our opinion, provide a reasonable
basis for FCA's responses.
FCA took enforcement action in 1990 against an association in the
West that, based on its examinations in 1989 and 1990, FCA believed
was engaging in predatory pricing. No specific complaints had been
made against this association and it was not related to an assisted
FCB. FCA officials told us that examiners must document a pattern
and practice of predatory pricing before FCA will require an
institution to take corrective steps. In this case, FCA examiners
found that the association was pricing most loans only slightly above
the prime rate and well below the rates its competitors were offering
borrowers of equivalent creditworthiness. The association was in
poor financial condition and needed to increase earnings to shore up
its capital base. Among other things, FCA directed this association
to increase the rates it was charging and to survey its competitors
regularly.
In another case, FCA warnings to an association preceded a specific
complaint. In a 1991 examination, FCA noted that a high percentage
of one midwestern association's loans were priced at the rates
reserved for its most creditworthy borrowers. These rates were low
relative to those of its competitors. Examiners criticized the
association for failing to document how competitive rates influenced
its rate structure and warned that predatory pricing complaints might
be made against it. Since the association was well capitalized and
profitable, FCA took no other action. A short time later, a
predatory pricing complaint was made against the association. It was
one of the 12 complaints cited above that FCA investigated and
rejected. The association was located in an assisted FCB's
territory.
--------------------
\7 FCA routinely requested the names of the customers involved and
other detailed information from those who made these allegations
beginning in 1990; it received complete responses in only four cases.
ASSISTANCE BOARD APPROVED
NEW LOAN PRICING POLICIES OF
ASSISTED FCBS
-------------------------------------------------------- Chapter 3:2.3
The Assistance Board generally agreed with FCA's definition of
predatory pricing. It focused on the impact of the assisted FCBs'
loan pricing practices on the banks' long-run viability. The
Assistance Board required some of the assisted FCBs to hire outside
consultants to help design new asset/liability management strategies,
including new loan products and pricing programs. Assistance Board
officials did not believe any assisted FCB priced loans improperly or
competed unfairly.
Under the 1992 act, FCSIC is the successor to the "assistance
agreements" between the Assistance Board and the assisted FCBs. The
assistance agreements quote from the Farm Credit Act and FCA
regulations in describing the objectives of the new loan pricing
policies. More specifically, the assistance agreements state that no
assisted FCB should make loans at rates below its marginal cost or
competitive market rates. The Assistance Board defined "marginal
cost" as the monthly cost of funds plus operating expenses less the
impact of adjustments to the allowance for loan losses. Some
assisted FCBs compare their interest rates with this formula
directly. All supplied the Assistance Board with extensive
asset/liability management information. The Assistance Board also
received regular reports on the assisted FCBs' surveys of competitive
market rates. While associations operating in the assisted FCBs'
districts did not submit reports to the Assistance Board documenting
their compliance with these standards, the Assistance Board expected
the FCBs to monitor them and regularly reviewed information on
association financial condition and performance. FCSIC officials
plan to monitor assisted FCBs in a similar fashion.
Assistance Board officials appeared to rely primarily on the marginal
cost criteria to assess compliance with the assistance agreement
conditions on loan pricing. Competitive market rates, they said,
were difficult to use because surveys of prevailing rates may not be
accurate. They pointed out that competition for the business of some
high-quality, low-risk borrowers is intense. This may result in both
System institutions' and other lenders' granting preferential rates
to selected customers.
Assistance Board officials discussed allegations of predatory pricing
with management of the assisted FCBs and FCA examiners. They also
spoke with commercial bankers and trade associations who made
complaints. The Assistance Board referred the few specific instances
of alleged predatory pricing that were brought to its attention to
FCA for further investigation.
COST STRUCTURES OF THE SYSTEM
AND OTHERS
---------------------------------------------------------- Chapter 3:3
GSE status provides the System with cost advantages over other
agricultural lenders. These advantages enable it to legitimately
offer lower rates on at least some types of farm loans and still earn
profits. Moreover, because it is a cooperative, the System may
target lower profit margins than its competitors. This suggests that
System institutions may have advantages in cost of funds and required
profit margins. We could not determine whether System institutions
have advantages with respect to operating costs, the other component
of the cost of making loans.
To determine how agricultural lenders set rates on loans, we
interviewed officials at selected System institutions, commercial
banks, and insurance companies. We constructed a hypothetical
agricultural real estate loan and a hypothetical farm operating loan
and asked the lenders to "price" them. The rates they quoted varied
widely. Some System institutions used a worksheet to derive target
rates on the loans by adding up their cost of funds, expected costs
of servicing the loans, a premium for accepting prepayment risk and
credit risk, and a profit margin. Some commercial bankers went
through a comparable exercise to set their desired loan rates. But
both types of lenders also recognized the necessity of adjusting
their rates to meet the competition. Both said they offer especially
attractive rates to certain borrowers to develop or continue a
long-term relationship.
While agricultural lenders may calculate their target loan rates by
adding their expected costs and a margin for profit, individual
lenders probably have little control over prevailing rates in the
highly competitive agricultural credit market. It might be more
realistic, therefore, to view these calculations as profitability
rather than pricing exercises. The lender will only make the loan if
the spread between prevailing rates and what the loan will cost is
large enough to reach a profit target.\8 Consequently, individual
lenders' cost structures determine what kinds of loans they are
willing to make as well as influencing the prices of these loans.
Ultimately, their costs will also determine how many loans they make
and what their share of the market will be. Agricultural lenders'
costs have three components:
Cost of funds. For System institutions, this is the rate they must
pay on the bonds they issue in the national capital markets.
For commercial banks, the cost of funds depends largely on what
they must pay to attract deposits.
Operating and overhead costs. These are the costs incurred in
making and servicing loans and the overhead associated with
running a financial institution.
Profit margins. To obtain capital, profit margins on loans must be
sufficient to offer stockholders the prospect of an acceptable
rate of return on their investment.
Precise comparisons of the costs various agricultural lenders incur
are problematic. For one thing, lenders' records do not isolate how
much servicing particular loans or types of loans costs them. We
can, however, identify areas where evidence suggests that cost
differentials exist.
--------------------
\8 For insurance companies, agricultural lending decisions are
further constrained by the need to harmonize agricultural loans with
the composition and maturity of the company's overall portfolio. Our
discussions with insurance companies indicated that they do not use,
either explicitly or implicitly, the kind of build-up or cost-plus
pricing that System institutions and commercial banks do.
COST OF FUNDS
-------------------------------------------------------- Chapter 3:3.1
There is evidence that the System's GSE status, with access to
national capital markets, affords a competitive advantage in raising
funds for long-term lending. Long-term debt issued by System banks
and insured by FCSIC sells at rates comparable to debt issued by
AAA-rated firms--a credit rating that only one U.S. commercial bank
currently enjoys. In fact, most commercial banks lending to farmers
do not have direct access to long-term funds.\9 This advantage
probably accounts for the System's dominance in the market for farm
mortgages. While the System has a cost advantage over commercial
banks in raising long-term funds, that advantage does not extend to
life insurance companies. Premium income provides life insurers with
long-term funds that have enabled them to capture 13 percent of the
market for farm mortgages.
On the other hand, the System does not appear to have any advantage
over commercial banks in obtaining short-term funds. If we use the
weighted average of rates on savings accounts and certificates of
deposit to measure their cost of funds, then commercial banks' cost
of funds are low. Bank rates on federally insured savings accounts
and certificates of deposit are usually lower than rates on
short-term Treasury bills, while the System typically issues
short-term bonds and notes at rates above those on Treasury bills.
Market share evidence supports this view. At the end of 1991,
commercial banks made 50 percent of farm operating loans, while
System institutions accounted for only 15 percent.
--------------------
\9 Commercial banks have some indirect access to long-term funds for
agricultural lending through System banks and Farmer Mac. For
example, commercial banks that lack sufficient funds to meet demand
for farm loans can "discount" or sell such loans to System banks or
borrow from the FCBs just as associations do. Few of them choose to
exercise this option, however. One of the purposes of establishing
Farmer Mac in 1988 was to enable commercial banks to offer long-term
mortgages by promoting the development of a secondary market for the
sale of agricultural real estate and rural housing loans. Farmer Mac
does not yet play a major role in agricultural credit.
OPERATING COSTS
-------------------------------------------------------- Chapter 3:3.2
In addition to the cost of funds, agricultural lenders incur many
other costs in operating a financial institution. For example, a
lender must assess a borrower's creditworthiness, process loan
payments, and update information about the borrower's business over
the life of the loan. Lenders also incur fixed costs for buildings,
licenses, examinations by regulators, etc.
Differences in structure, charter, and regulatory requirements for
the System and commercial banks make direct comparisons problematic.
For example, both System institutions and commercial banks must now
pay insurance premiums. Since System institutions pay FCSIC a
premium of 15 basis points on accruing loans and commercial banks pay
the Federal Deposit Insurance Corporation, on average, 25.4 basis
points on domestic deposits, System institutions would appear to have
lower insurance costs. However, the commercial banks that raise
large amounts of funds through foreign deposits or other sources
(primarily large banks) pay less per dollar of assets for insurance
than System institutions of the same size.\10
Likewise, while FCA and commercial bank regulation is similar, the
regulatory burdens are not identical. For example, System
institutions are expected to lend to all eligible farmers as well as
comply with various state and certain unique federal borrower rights
laws that apply to farmers. On the other hand, commercial banks must
meet the requirements of the Community Reinvestment Act of 1977 (P.L.
95-128, 91 Stat. 1147). This law is designed to encourage banks to
help meet the credit needs of their local communities in which they
are chartered, consistent with safe and sound operations. Commercial
banks receive and must disclose ratings on how well they fulfill
these objectives.
Our review of the handful of studies comparing the operating costs of
System institutions and commercial banks did not permit any strong
conclusions. However, the limited evidence available suggests that a
lender's size is more important than its charter. Some studies
suggest that the System's cost of making agricultural loans is
comparable to that of large commercial banks and lower than that at
small banks.
--------------------
\10 Loans comprise more than 80 percent of assets at most System
institutions, while domestic deposits equate to, on average, just
over 50 percent of assets for all commercial banks. However, this
percentage is much higher for small banks (about 90 percent for banks
with total assets of less than $25 million) than for large ones.
PROFIT MARGINS
-------------------------------------------------------- Chapter 3:3.3
The System acquires capital by requiring borrowers to purchase stock
as a condition for receiving a loan. Minimum stock purchases have
been reduced to 2 percent of the loan balance or $1,000, whichever is
less, from 5 to 10 percent historically. In the past, most
borrowers' stock was automatically redeemed when the loan was repaid.
Today, System member-borrowers may be required to retain their stock
for some period, whether or not they receive dividends or patronage
refunds. Commercial banks raise capital by offering investors a
share of their earnings through dividends or capital gains. System
institutions and commercial banks can also retain earnings to build
capital.
A System institution can benefit its member-borrowers by earning
profits to pay dividends or by offering a discount on loan rates as
an indirect dividend payment. The tax exemptions available to System
institutions allow them to retain or distribute more of their
earnings than commercial banks can.\11 On the other hand, if a System
institution does not pay dividends, or pays dividends that do not
compensate for risk, then the loans it makes must carry lower rates
than those offered by other lenders who do not require a stock
purchase. System institutions inform borrowers of the effective rate
on their loans assuming that no dividends are paid on the required
stock purchase.
--------------------
\11 FCBs, FLBAs, and FLCAs are exempt from most taxes. BCs, PCAs,
and ACAs are not tax-exempt, but as cooperatives they can distribute
their earnings to member-borrowers and thus avoid the corporate taxes
that a commercial bank would have to pay.
LOAN RATES OF THE SYSTEM AND
OTHERS
---------------------------------------------------------- Chapter 3:4
Average rates on System loans at the national level and in selected
local market areas fall between the average rates charged by large
and small commercial banks. In the Midwest, data we collected and
analyzed suggest that even on similar kinds of loans, System
institutions charge rates that are lower than those offered by nearby
small (assets up to $500 million) agricultural banks. It is not
clear, however, how much of the difference in rates is due to the way
these two types of lenders set loan prices and how much is due to
other factors.
NATIONAL AVERAGE RATES ON
FARM LOANS
-------------------------------------------------------- Chapter 3:4.1
At the national level, data compiled by USDA show that in the fourth
quarter of 1991 (the latest period for which all figures were
available during our review), average rates on operating loans ranged
from 8.10 percent at large commercial banks to 10.70 percent at small
commercial banks. Commercial banks supplied about half of all farm
operating loans in 1991. The difference of 2.60 percentage points
between large and small banks is presumably related to advantages of
scale. For example, large banks may demand a smaller risk premium
because of their ability to diversify risk. In addition, because
they make larger loans that are less costly to service, they may
incur lower per unit costs. In comparison to banks, interest rates
charged by System institutions in the fourth quarter of 1991 averaged
9.86 percent\12 on operating loans, 1.76 percentage points more than
large banks but 0.84 percentage points less than small banks.
During the same period, interest rates on agricultural real estate
loans from System institutions averaged 9.46 percent. The System
held about 33 percent of all farm mortgages in 1991, and insurance
companies, the other traditional suppliers of these loans, held about
13 percent. There was little difference between the average rates
System institutions and insurance companies charged. As was the case
with operating loans, System lending rates for farm mortgages were,
on average, higher than rates at large banks but less than rates at
small banks. Interest rates on agricultural real estate loans at all
commercial banks averaged 9.74 percent in the fourth quarter of 1991,
with large banks charging an average rate of 9.14 percent and small
banks charging an average of 10.27 percent. Figures 3.1 and 3.2
present the average rates charged by the major agricultural lenders
on both types of loans from 1970 to 1991.
Figure 3.1: Interest Rates on
Farm Operating Loans, Annual
Average, 1970-1991
(See figure in printed
edition.)
Source: USDA.
Figure 3.2: Interest Rates on
Agricultural Real Estate Loans,
Annual Average, 1970-1991
(See figure in printed
edition.)
Source: USDA.
--------------------
\12 Assuming a System institution pays no dividends over the life of
the loan, the minimum stock purchase requirement has the effect of
adding 0.20 percentage points to the rate on loans under $50,000.
The USDA figures for average rates presented do not consider System
stock and, thus, are slightly lower than the average effective rates
on System loans.
FARM LOAN RATES IN REGIONAL
AND LOCAL MARKETS
-------------------------------------------------------- Chapter 3:4.2
Unfortunately, there are few data on agricultural loan interest rates
in regional and local markets, although there are meaningful
differences between regional and local rates and the national
averages. For example, in the fourth quarter of 1991, the average
interest rate on operating loans reported by commercial banks in the
Richmond Federal Reserve district was 9.40 percent, compared to 11.00
percent in the Minneapolis district. Similarly, average rates for
new System operating loans ranged from 9.09 percent in the territory
served by the Baltimore FCB to 10.67 percent in the Western district.
Since much of the controversy over the System's loan pricing
practices focuses on the Midwest, we collected and analyzed data on
farm loans made in 1991 by System institutions and small commercial
banks competing in 12 selected midwestern local markets. These areas
were served by three different FCBs. We found the same relationship
in these local markets that the national averages suggest: System
rates appear to be lower than those of small banks, even on similar
kinds of loans.
In 10 local markets, we could directly compare the mean effective
rates on System and small bank operating loans.\13 In all of these
markets, the average rate on loans made by System institutions was
either lower than or not meaningfully different from\14 the average
rate on loans made by the small banks in the same area in 1991. In 8
out of the 10 areas, the average System loan rate was lower in at
least one quarter during 1991. These comparisons of average rates on
loans made by the two lenders could be misleading, however. For
example, the average rates could be different not because of the way
the loans were priced, but because of differences in the
characteristics of the loans.
To examine this further, we employed multiple regression analysis to
test the relationship between the effective rates on similar System
and small bank loans. Using this technique, we could compare rates
in all 12 local markets for both farm operating and real estate
loans. Our regression model included variables to control for
differences in the size, maturity, and other characteristics of the
loans as well as when and where they were made. Results from this
analysis suggest that System rates tend to be lower than small bank
rates, even for similar kinds of loans. On operating loans, System
rates were estimated to be 0.59 percentage points less than rates
charged by competing small banks. On real estate loans the
difference was somewhat greater, with rates at System institutions
estimated at 0.99 percentage points less than rates at these
banks.\15
Our regression model explained only a limited portion of the
difference between System and small bank loans. Thus, we were not
able to determine conclusively whether these differences were due to
some unknown loan characteristic (such as the borrower's
creditworthiness) or to systematic differences in the way the lenders
priced the loans. Nonprice competitive factors may also play a role.
Surveys of farmers reveal that loan rates are not the only thing
farmers consider when they choose a lender. Factors such as the
level of service the lender provides also enter into these decisions.
Although the inferences we can draw from our statistical analyses of
prevailing rates in local markets are limited, they are generally
consistent with both the national data on farm loan rates and the
cost-based comparisons presented in the last section. We describe
our statistical analyses in more detail in appendix II.
--------------------
\13 The effective interest rate is defined as the nominal rate of
interest adjusted for the frequency of interest compounding and the
System stock purchase requirement, assuming no dividends are paid on
the stock over the life of the loan.
\14 Technically, there was no statistically significant difference
between the rates charged by the two lenders.
\15 This difference is consistent with the hypothesis that the
lenders' cost structures give them advantages in making certain types
of loans, as reflected in market share data.
CONCLUSIONS
---------------------------------------------------------- Chapter 3:5
Although the System has cost advantages over some competitors due to
its GSE status, our economic analysis uncovered little evidence to
support charges of predatory pricing by System institutions. On
average, rates on System loans are lower than those offered by small
commercial banks, higher than rates at large banks, and about the
same as rates available from insurance companies. While some System
institutions have been competing aggressively in recent years, we
agree with FCA and the Assistance Board that such competition was,
with few exceptions, legitimate. At System institutions whose loan
pricing practices presented safety and soundness concerns, FCA and
the Assistance Board took action to encourage or require corrective
steps.
THE SYSTEM'S CHARTER AND THE
QUESTION OF EXPANDED POWERS
============================================================ Chapter 4
The System's current role and mission were set out in the early
1970s, although some minor changes have been made in recent years.
This chapter reviews some of these changes and notes issues that
would need to be resolved before any major expansion in the System's
authorities is granted. The System's charter may need to be modified
as agriculture and rural America continue to change.\1 However, we do
not believe the System needs expanded authorities to ensure its
viability in the near term.
--------------------
\1 Our earlier report in response to 2 of the 10 mandated study
questions addresses credit availability in rural America in more
detail. See Rural Credit: Availability of Credit for Agriculture,
Rural Development, and Infrastructure (GAO/RCED-93-27, Nov. 25,
1992).
SYSTEM HAS A LIMITED CHARTER
---------------------------------------------------------- Chapter 4:1
Like other GSEs, the System has a limited charter because it was
established to serve a specific economic sector--in this case,
agriculture. The Farm Credit Act and FCA regulations specify who the
System may serve and which lines of business it may engage in. The
System makes credit and other services available to all eligible
borrowers across the nation. The System is not required to serve
borrowers that cannot get credit elsewhere because of their poor
financial condition, but it can and does compete with private sector
lenders for the most creditworthy borrowers.
The FCBs and related associations can lend to farmers, ranchers,
producers or harvesters of aquatic products, some farm-related
businesses, and rural homeowners. The BCs may serve agricultural and
aquatic cooperatives (and other entities that do business with
cooperatives), and rural utilities. The BCs also finance exports and
imports of goods and commodities produced by cooperatives. CoBank
makes most of these loans, nearly all of which carry federal
guarantees through the Commodity Credit Corporation. Figure 4.1
shows the composition of the System's loan portfolio as of December
31, 1992.
Figure 4.1: Composition of the
Farm Credit System Loan
Portfolio, 1992
(See figure in printed
edition.)
Source: GAO.
The Farm Credit Act and FCA regulations restrict the types of loans
the System can make and set conditions for some lines of business.
Some of these restrictions exist to ensure that System institutions
remain focused on agricultural lending. Others limit competition
between System institutions and other financial institutions. For
example, FCBs and associations can lend to rural homeowners (other
than farmers and ranchers) who live in towns with not more than 2,500
inhabitants. Such loans must be to buy, build, or improve a
moderately priced home and may not total more than 15 percent of the
loans in an FCB's portfolio. As another example, FCBs must get prior
approval from FCA before they can offer technical assistance,
insurance, or other financially related services to farmers. They
must also show that they and their related associations can offer
these kinds of services without compromising their core business. We
support close regulatory oversight when financial institutions expand
into new lines of business.
RECENT CHANGES AND PROPOSALS
FOR CHANGES IN SYSTEM'S CHARTER
HAVE BEEN RELATIVELY MINOR
---------------------------------------------------------- Chapter 4:2
Congress has approved or considered numerous minor changes to the
System's charter over the past several years. Those advocating
updated and expanded powers argue that the System needs them so it
can continue to meet farmers' needs while competing with other
institutions as financial services markets evolve. They have also
proposed changes in System authorities on the grounds that certain
credit needs in rural America are not being met. Opponents of such
changes contend that increased competition from the System would make
an already unfair situation worse, making it harder for some
competitors (such as small banks) to survive.
One change to the System's charter was authorized by the Food,
Agriculture, Conservation, and Trade Act of 1990. That law modified
the rules on System financing of processing and marketing operations
of eligible farmers. Previously, FCBs and associations could make
these kinds of loans only if the member-borrower produced at least 20
percent of the output handled by the processing or marketing
organization. Current law requires only that the applicant supply
"some portion" of the organization's throughput. The law does,
however, set a 15-percent limit on the percentage of an FCB's
portfolio that may consist of loans made under the new, less
restrictive standards on throughput.
Another change to the System's charter was authorized by the 1992
act. It involves the System's role in financing rural development.
The 1992 act removes restrictions on System institutions' guarantees
of tax-exempt instruments such as municipal bonds issued by rural
communities to fund water systems or other infrastructure projects.
CoBank will probably do most of this business; it already has
experience in lending to rural utilities. Our study on rural credit
availability notes that some state and local governments are
concerned about their ability to finance needed rural infrastructure
improvements. However, in some areas, the study points out, the tax
base is too small to support large bond issues or to repay loans;
many rural communities cannot service even subsidized debt.\2 Thus,
it is not clear how much of the unmet need for this type of credit
System institutions or any other commercial lender can fill.
System advocates have proposed changing the definition of "rural
homeowner" to permit the System to serve such borrowers in
communities with populations up to 20,000 rather than 2,500.\3
Opponents of this change, including ABA, point out that many FCBs do
not fully use their existing authority. Advocates counter that the
current size of FCBs' rural housing portfolios does not show the true
demand for System rural home loans. We did not find any data
conclusively establishing whether there is an unmet need for rural
housing loans in general. In another recent study, however, we found
the greatest need among high-risk borrowers who do not meet most
lenders' (including the System's) credit standards.\4
--------------------
\2 See Rural Credit: Availability of Credit for Agriculture, Rural
Development, and Infrastructure (GAO/RCED-93-27, Nov. 25, 1992).
\3 The Farmers Home Administration uses a 20,000-population limit
(for communities outside metropolitan statistical areas) to establish
eligibility for its primary program for rural housing.
\4 See Federal Agricultural Mortgage Corporation: Potential Role in
the Delivery of Credit for Rural Housing (GAO/RCED-91-180, Aug. 7,
1991).
SHOULD THE SYSTEM BE ALLOWED TO
DIVERSIFY BEYOND AGRICULTURE?
---------------------------------------------------------- Chapter 4:3
Before the 1992 act, the question of allowing the System to diversify
beyond agriculture was being examined. For example, in 1990 the
Treasury proposed that all GSEs obtain AAA ratings (the highest
possible) from nationally recognized rating organizations on the
basis of their financial condition and performance, not their GSE
status.\5 The System responded that it would be virtually impossible
for it to attain such a rating because of its restricted charter and
the volatile, high-risk nature of agriculture. As with all GSEs,
there is a tradeoff between the System's serving its public purpose
and the risk of concentration in one economic sector.
Our analysis suggests that, in the near term, the System does not
need far-reaching changes to its charter to ensure the viability of
most institutions. Total U.S. farm debt and the System's share have
stabilized, and, as we noted earlier, most System institutions are
operating profitably and are on target toward meeting their
assistance repayment and other obligations. Some FCBs are holding
higher levels of investments in government securities or other
financial instruments than they traditionally have. System officials
point out that this is one way of diversifying risk away from
agriculture. Proposed FCA regulations would limit System
institutions' holdings of investment securities to 20 percent of
assets, reflecting FCA's belief that the System should not use its
GSE status to make excessive investments.
In the long term, changes in the role and mission of the System need
to be considered in light of continuing structural change in
agriculture and in rural America. This could involve simply updating
the System's charter to ensure that it is not hampered by outdated
restrictions in serving its existing customer base. Alternatively,
if judged desirable in the context of the nation's rural development
agenda, the System's powers could be expanded so that it can serve
new customers. More structural change and consolidation in the
System may be needed, as well.\6
Many small commercial banks may also need to find new business
opportunities or merge with larger institutions. A 1990 study noted
that the share of farm debt held by small agricultural banks declined
about 5 percentage points during the 1980s.\7
The study also suggests that only those commercial banks (and System
associations) that are large and efficient enough to offer a range of
financial services will be able to maintain or expand their markets.
Thus, since most observers expect farm debt to grow slowly, this may
be the only way to preserve adequate levels of income.
In agriculture, a trend toward fewer, larger, and more
capital-intensive farms has been under way for decades. According to
USDA estimates, over half of the nation's food and fiber is now
produced by the 100,000 or so largest farms that have annual sales
over $250,000. And, while only about 1 in 7 of the approximately 2
million farms has annual sales over $100,000, these larger farms
account for roughly two-thirds of total farm debt. Agricultural
lenders will certainly pursue these valuable customers. At the other
end of the spectrum, most small farmers rely on off-farm income to
support themselves and their families. These part-time operations
are more numerous, but do not require large amounts of credit.
The rural economy has shifted away from its traditional reliance on
agriculture and other natural resource industries. According to
USDA, these industries now directly employ fewer than one rural
resident in eight. Moreover, during the 1980s, the only rural places
that grew relative to metropolitan areas were retirement communities
and trade centers that benefited from the demise of neighboring small
towns.
--------------------
\5 The System, like other major GSEs, has an AAA rating because of
its ties to the government. In a 1991 Treasury study, one rating
organization indicated that, without GSE status, the System would be
rated BB. This rating is below the investment-grade range and is
considered speculative or high-risk.
\6 The 1992 act requires us to report to Congress on the advantages
and disadvantages of merging the FCBs into fewer, regional banks. As
noted in chapter 1 of this report, during 1992 and 1993, mergers were
consummated or announced that will reduce the number of System banks
in the near future.
\7 See Alan D. Barkema and Mark R. Drabenstott, "The Outlook for
Agricultural Lenders and Policymakers in the 1990s," in Financing
Agriculture in the 1990s: Structural Change and Public Policy,
Proceedings of the 1990 Meeting of the Federal Reserve Committee on
Agriculture and Rural Development, Federal Reserve System,
Washington, D.C., 1991.
COMPETITIVE AND OTHER ISSUES
RAISED BY EXPANDED POWERS
FOR THE SYSTEM
-------------------------------------------------------- Chapter 4:3.1
Questions about the impact of increased competition on other rural
financial institutions would inevitably accompany a major expansion
in the System's charter, just as they have been raised in debate on
the relatively minor changes discussed in recent years. In addition,
there are at least two other issues that would need to be addressed.
Which System institutions should be granted new powers? Should new
borrowers who are not agricultural producers be required or allowed
to buy stock in System institutions?
As agricultural finance becomes more sophisticated, the traditional
division between the FCBs and associations and the three BCs is
blurring. For example, several FCBs have recently participated in
large BC (CoBank) loans to finance agricultural exports to the former
Soviet Union. CoBank's management is committed to actively seeking
these and other opportunities for growth and development of new
business, including lending to noncooperatives. Doing so could place
the institution in the position of financing nonmembers who are in
direct competition with CoBank voting stockholders, a situation the
bank has promised to make reasonable efforts to avoid. This points
up the need to decide to what extent the System should remain an
agricultural cooperative as expanded powers are evaluated.
An official at the Farm Credit Council, the System's trade
organization, told us that a System work group is being formed to
discuss changes in the System's charter, including these issues.
Opinions on how System powers should be expanded and how to integrate
new lines of business differ among System institutions and, in some
cases, between their directors and management, we were told.
CONCLUSIONS
---------------------------------------------------------- Chapter 4:4
With the System, as with all GSEs, there is a tradeoff between
meeting a public purpose and concentration in one economic sector.
The System does not need expanded powers to ensure its viability in
the near term. However, over time, as agriculture and rural America
continue to change, the System's charter may need to be modified to
bring it up to date and, if judged desirable within the context of
the nation's rural development agenda, expanded to allow the System
to serve new customers.
AGENCY COMMENTS AND OUR EVALUATION
============================================================ Chapter 5
We requested comments on a draft of this report from the System, FCA,
FCSIC, and ABA. All four organizations provided written comments,
which appear in appendixes III through VI. Their views are presented
and evaluated in this chapter. More detailed responses to certain
points appear in the appendixes. Changes responding to technical
comments were incorporated directly into the text where appropriate.
The commenters expressed widely varying opinions on our analysis,
conclusions, and recommendations. This diversity of opinion
illustrates that federal assistance to the System and the System's
position in the agricultural credit market remain controversial
issues, just as they were during the mid-1980s crisis.
OVERALL COMMENTS
---------------------------------------------------------- Chapter 5:1
Only the System and FCA made comments on the draft report as a whole.
The System stated that, while there was much in the draft report with
which it agreed, there were several areas with which it took strong
exception. The System also expressed the opinion that our work did
not appropriately respond to the requirements outlined in the statute
that mandated us to conduct this study. FCA commented that, overall,
the draft report was balanced and well researched.
The System stated that the draft of this report failed to
specifically address 6 of the 10 mandated study questions dealing
with other agricultural lenders. In response, we note that all eight
questions addressed in this report concern the System; those covered
in chapters 3 and 4 also concern other lenders active in rural
America. In addition, as indicated on page 1 and elsewhere, this
report is the second report we issued to fulfill the statutory
requirements. Two of the 10 mandated questions were addressed in our
earlier report entitled Rural Credit: Availability of Credit for
Agriculture, Rural Development, and Infrastructure (GAO/RCED-93-27,
Nov. 25, 1992).
The System also stated that this report did not address the mandated
questions on the System's ability to remain competitive while
repaying assistance, but focused instead on accounting issues
surrounding FCSIC and other matters not raised by Congress as issues
or concerns. We believe these questions and issues are closely
interrelated and that we appropriately addressed them.
COMMENTS ON CHAPTER 2
---------------------------------------------------------- Chapter 5:2
The System took strong exception to our positions on the assistance
repayment and FCSIC issues discussed in chapter 2 and disagreed with
all of our recommendations. FCA, FCSIC, and ABA generally agreed
with our conclusions and supported our recommendations on these
issues.
REPAYMENT OF 1987 ACT
ASSISTANCE
-------------------------------------------------------- Chapter 5:2.1
Stating that both of our recommendations on assistance repayment
should be rejected, the System reaffirmed its support for the
framework of the 1992 act. In the System's view, this framework best
supports the objective of complete financial recovery for the System
and best serves the public policy goal of maintaining the System as a
dependable source of credit for farmers and their cooperatives. We
agree that the 1992 act addressed some significant weaknesses of the
1987 act, but we continue to believe that the overall framework for
assistance repayment can and should be further improved. FCA and
FCSIC generally agreed with our recommendations regarding assistance
repayment. ABA also agreed with these recommendations but had no
specific comment on them.
RECOMMENDATION ON
ACCOUNTING FOR ASSISTANCE
------------------------------------------------------ Chapter 5:2.1.1
The System stated that our recommendations on improving the
accounting and regulatory treatment for assistance repayment
obligations implicitly ask Congress to abandon the financial
assistance structure of the 1987 and 1992 acts. It added that, in
certain instances, our recommendations would impose regulatory
accounting principles instead of GAAP. The System also took the
position that the 1992 act mechanisms will render most of our
recommendations moot as banks make annual payments to FAC.
We expanded and clarified our discussion of the 1987 act assistance
program in chapter 2 in response to the System's comments. Our
objectives in doing so were to clarify why we believe making changes
in current law and in the System's accounting practices would better
achieve the goals of the 1987 act. We did not and do not advocate
that the System adopt regulatory accounting principles instead of
GAAP. Our position is that both System banks and the System as a
whole should use the most appropriate and meaningful GAAP treatment
for assistance. We changed the wording of our recommendation to
Congress regarding System banks' accounting practices to emphasize
this.
In our draft report, we focused on the need for System banks to
record liabilities for those categories of assistance they must repay
on specific dates: the CPA payables, Other uses, and Treasury
interest advances. FCA agreed with us that System banks should
record liabilities for these categories at their face amounts, except
with regard to the Treasury interest advances. FCSIC concurred with
FCA's position, adding that recording such liabilities would
facilitate better analysis of individual System banks' financial
condition and performance. Having considered these matters further,
we now believe that the Treasury interest advances should not be
viewed as a separate assistance category. Rather, as FCA and FCSIC
pointed out, these advances provide an economic benefit to the
System. They reduce the effective cost to the System of repaying
much of the 1987 act assistance. Therefore, we concluded that the
System should reflect the economic benefit associated with the
Treasury interest advances in the accounting entries it makes for the
main assistance categories, instead of presenting repayment of the
advances as a separate cost. We changed the text of chapter 2
accordingly.
RECOMMENDATION ON
REGULATORY TREATMENT OF
ASSISTANCE
------------------------------------------------------ Chapter 5:2.1.2
The System's comments suggest that it believes regulatory relief may
be needed by some System banks, if not now, then at some time before
assistance is repaid. For example, the System wrote that the
"transition period" through the year 2000 for the Treasury interest
advances "recognizes the uncertainties of the agricultural economy
and the remaining levels of nonaccrual loans" at some System
institutions. We believe System banks should accumulate at-risk
capital to deal with these business realities, as most of them are
already doing. In our view, no System bank should be relying on any
kind of regulatory relief instead. Nor do we believe continuing the
regulatory relief for System banks will contribute to their ability
to repay assistance. We still believe that this relief is both
inappropriate and unnecessary.
FCA suggested we modify our recommendation to Congress regarding
counting all assistance as temporary, not permanent capital of System
banks for regulatory purposes. FCA noted that our recommendation
could be directed to it if Congress granted FCA the discretion to
define permanent capital by regulation. We agree with the principle
of granting federal regulators of financial institutions, including
FCA, discretion to set regulatory capital standards, subject to
congressional oversight. Accordingly, our final report recommends
that Congress provide FCA statutory authority to count 1987 act
assistance to System banks as temporary rather than permanent capital
for regulatory purposes.
FCSIC recognized our recommendation addressed only System assistance
from FAC, but it is concerned about any legislative constraints on
future assistance it might provide to troubled institutions. FCSIC
commented that it believes FCA should have the flexibility to
determine what types of FCSIC assistance could count as permanent
capital. We plan to address FCA's and FCSIC's views on the
regulatory treatment of future assistance from FCSIC as part of our
study of FCSIC issues required by the 1992 act.
FCSIC ISSUES
-------------------------------------------------------- Chapter 5:2.2
The System urged us to withdraw both of our recommendations regarding
FCSIC and the Insurance Fund. FCA and FCSIC suggested further
analysis be done before implementation of the first recommendation
requiring repayment of the $260 million provided by Treasury. FCA
and FCSIC supported the second recommendation requiring the exclusion
of the Insurance Fund from the System's financial statements, but
they again felt that additional study would be necessary before any
action was taken. However, in December 1993, FCA formally accepted a
System proposal for additional disclosure in the notes to the
System's combined financial statements on the treatment of the
Insurance Fund as System assets and capital. According to FCA, this
revised form of disclosure on the Insurance Fund resolves its
concerns. ABA supported our recommendations on FCSIC issues on the
grounds that implementing them would promote fairer competition
between the System and commercial banks.
RECOMMENDATION TO REQUIRE
REPAYMENT OF $260 MILLION
TRANSFERRED TO FCSIC
------------------------------------------------------ Chapter 5:2.2.1
The System strongly disagreed with our recommendation that Congress
require FCSIC to reimburse the Treasury for its initial capital
infusion of $260 million and urged us to reconsider it. Among other
things, the System said that the transfer of the $260 million from
the FCA-administered revolving fund to FCSIC was consistent with its
historical use for the benefit of the System and agriculture and did
not reduce the industry-financed nature of the Insurance Fund.
However, as also noted in the System's comments, the amounts in the
revolving fund were not originally supplied by System institutions,
but by taxpayers in general. Thus, this portion of the Insurance
Fund cannot be said to have been industry-financed.
The System further noted that the Insurance Fund is on budget, just
as the revolving fund was on budget. FCSIC also pointed this out,
adding that returning the $260 million to the Treasury would not
reduce the federal deficit. We agree that doing so would not have an
immediate budgetary impact. However, if FCSIC collected an
additional $260 million from System institutions to capitalize the
Insurance Fund, over time, taxpayers in general would have to pay
that much less for other public purposes. FCSIC also commented that
should Congress pursue this recommendation, the timeframe in which
repayment of the $260 million would be required would be critical.
We generally agree with FCSIC on this point. Our recommendation
states that Congress should consider the financial condition of the
System and the Insurance Fund before taking action.
RECOMMENDATION TO EXCLUDE
INSURANCE FUND FROM
SYSTEM FINANCIAL
STATEMENTS
------------------------------------------------------ Chapter 5:2.2.2
The System also strongly disagreed with our recommendation to exclude
the Insurance Fund from the System's financial statements. It urged
that we withdraw this recommendation and, instead, recommend that FCA
and the System jointly submit the matter for resolution to the
Financial Accounting Standards Board (FASB). FCA wrote that it
intends to review and may develop a regulation concerning the
System's accounting treatment of the Insurance Fund. FCSIC concurred
with FCA, suggesting that the issues involved need to be analyzed
further during the development phase of such a regulation. As noted
earlier, ABA supported this recommendation. Recently, FCA accepted a
System proposal for a form of disclosure in the notes to the System's
combined financial statements that lists the Insurance Fund
separately before combining it with System assets and capital and
provides supplemental information. The FCA board, in December 1993,
approved a proposed regulation on disclosure to investors that
incorporates the System's disclosure proposal. According to FCA, its
concerns about System disclosure for the Insurance Fund are resolved
by the System's proposal.
Addendum I to the System's comments, prepared by the Funding
Corporation, discussed the System's position on accounting for the
Insurance Fund and related matters at length. We reviewed our
earlier work in light of these comments and met with representatives
of the Funding Corporation and the System's external auditors to
discuss our differing positions at their request. We also had
further discussions with FCA and FCSIC officials. In response to the
System's, FCA's, and FCSIC's comments, we added appendix I to this
final report. It discusses how we believe GAAP applies to the
System's treatment of the Insurance Fund. Primarily because we
present and discuss the Funding Corporation's detailed comments in
appendix I, we did not separately reproduce them in this report.
Appendix III contains the System's summary of the Funding
Corporation's comments.
In the draft report, we did not give our views on how the System
should account for the Insurance Fund because FCA had already done
so. We believe FCA has the statutory authority to ensure that the
System is using what FCA determines to be an appropriate GAAP
treatment for the Insurance Fund. Further, we believe FCA oversight
of the System's accounting practices is important since the
System--like some other GSEs but unlike most major U.S.
corporations--is exempt from Securities and Exchange Commission
reviews of its financial reports.
We clarified our recommendation to FCA to address some of the
System's concerns with the wording used in the draft report. We
considered, but did not adopt, the System's suggestion that we
recommend submitting the Insurance Fund accounting issue to FASB's
Emerging Issues Task Force. We note the recent agreement between the
System and FCA on added disclosure for the Insurance Fund in the
notes to the System's combined financial statements, but still
believe that FCA should require the System to exclude the Insurance
Fund from its combined financial reports.
SYSTEM COMMENTS ON
EFFECTS OF EXCLUDING
INSURANCE FUND
------------------------------------------------------ Chapter 5:2.2.3
The Funding Corporation's comments state that it believes excluding
the Insurance Fund from the System's combined financial statements is
a "non-GAAP" accounting treatment. The Funding Corporation also
stated that if the System is required to adopt this treatment, the
likely result will be an increase in the System's cost of funds. The
Funding Corporation added that it believes this will, in turn,
negatively affect the financial condition of System institutions,
increase the cost of credit to agricultural producers and
cooperatives in general, or both.
For the reasons stated in appendix I, we disagree with the premise
that excluding FCSIC's Insurance Fund from the System's combined
financial statements is contrary to GAAP. We also believe that if
the Funding Corporation works constructively with the investor
community, FCA, and FCSIC, the risk of a negative reaction in the
capital markets due to this change in the System's accounting
practices can be minimized. As noted in chapter 2, even with this
change, the System's combined capital ratio would still have been
over 10 percent as of December 31, 1992. Because the banks' capital
positions are stable or improving, removing the Insurance Fund will
not seriously reduce the System's combined capital ratio if action is
taken soon. We do not think these accounting adjustments will have
any affect on the cost of agricultural credit.\1
In our draft report, we concluded that not only should the System
exclude the Insurance Fund in future periods, but that it should
restate its past financial information. We reached this conclusion
because the System's earnings since 1989 would have been much lower
if FCSIC premiums had been expensed. Restatement of past financial
reports is required when a change in reporting entity is made.
However, we believe this change may also be characterized as a
correction of an error, the cumulative effect of which would be
reported in the period the change is made.
--------------------
\1 Even if investors do react negatively to these changes, we believe
any resulting increase in the System's cost of funds is likely to be
only temporary. We do not think it would be significant enough to
cause an increase in the cost of agricultural credit in general.
There is ample credit available for agriculture at present, and, as
noted in chapter 1, both the System and commercial banks have
benefited from strong earnings in recent periods. This is in part
because they have not decreased lending rates as fast as their cost
of funds has fallen. Therefore, we believe that the System,
commercial banks, or both could absorb at least some cost increases
without having to raise farm loan rates.
COMMENTS ON CHAPTER 3
---------------------------------------------------------- Chapter 5:3
ABA was critical of our analysis of the predatory pricing controversy
addressed in chapter 3 and urged us to reassess our conclusions. The
System fully concurred with our conclusions. FCA had no comment on
chapter 3. FCSIC questioned the broad application of our conclusion
that the System has a cost of funds advantage over commercial banks.
REVIEW OF FCA OVERSIGHT
-------------------------------------------------------- Chapter 5:3.1
ABA expressed concern because we did not take note of what ABA
contends is an FCA predatory pricing definition that is contrary to
the applicable statute. In ABA's view, FCA's definition does not
conform to what ABA contends is the proper legal standard set out in
the policy section of the Farm Credit Act, and therefore, FCA's loan
pricing examinations and investigations of predatory pricing
complaints are not based on the proper legal standard. As noted on
page 56 of this final report, we believe FCA's definition of
predatory pricing is not, as asserted by ABA, contrary to applicable
law.
ECONOMIC ANALYSIS
-------------------------------------------------------- Chapter 5:3.2
ABA also found the draft report unclear as to what definition of
predatory pricing we used in our economic analysis. ABA further
stated that in its opinion, standard economic analysis is inadequate
to assess competition from GSEs such as the System. In the draft
report, we pointed out that some economists believe that public
entities, by their very nature, are likely to set prices that are in
effect predatory and thus harmful to private firms. This discussion
now appears on page 54. We acknowledge that standard economic
analysis does not establish that there is no predatory pricing in the
U.S. agricultural credit market under all valid economic definitions
of that term. However, we tried to take a middle-of-the-road
approach to the question of predatory pricing. We continue to
believe that the economic and statistical analyses we performed are
appropriate ways to approach the difficult issue of competition from
quasi-public entities like the System.
SYSTEM COST OF FUNDS
-------------------------------------------------------- Chapter 5:3.3
FCSIC was uncomfortable with any language that appeared to imply a
broad conclusion on a competitive advantage the System has over other
agricultural lenders. FCSIC stated that the cost of funds issue was
highly complex and was subject to future variations that are not
possible to predict. We think the data show that the System has a
cost of funds advantage at this time. We believe as FCSIC does that
this issue is complex and that the System's and commercial banks'
relative advantages in raising loanable funds may vary over time.
COMMENTS ON CHAPTER 4
---------------------------------------------------------- Chapter 5:4
ABA had further reservations about the analysis and conclusions
presented in chapter 4, our review of issues surrounding an expansion
of the System's charter beyond agriculture. ABA suggested that we
focus on whether the System is still necessary to support
agriculture, adding that in its view, the System should be allowed to
decline naturally if the answer to this question is no. The System
offered additional arguments in support of expanding its charter in
its comments, but took the position that, overall, there was little
that was controversial in our analysis. FCA stated that more work
needs to be done to arrive at a final public policy position on
expanded powers for the System. FCSIC had no comment. We modified
this final report to acknowledge these differing views at appropriate
places in chapter 4.
INSURANCE FUND ACCOUNTING ISSUES
=========================================================== Appendix I
As noted in chapter 2, the Farm Credit Administration (FCA) recently
accepted a System proposal for additional disclosure of the treatment
of the Insurance Fund as System assets and capital in the System's
combined financial statements. Previously, FCA staff had taken the
position that the Farm Credit System's accounting treatment of the
Insurance Fund was not in accordance with generally accepted
accounting principles (GAAP), which we continue to believe is an
appropriate position. FCA, however, has agreed to accept the
additional disclosures in lieu of further pursuit of a required
change in accounting by the System. While we agree the proposed
added disclosure is beneficial, disclosure is no substitute for
proper accounting. The System takes the position that presenting the
Insurance Fund as a restricted asset and as restricted capital of the
System is the most appropriate and meaningful GAAP treatment. In
comments on a draft of this report, the System disagreed with our
recommendation that FCA require the System to exclude the Insurance
Fund from its combined financial statements. The Funding
Corporation, which is responsible for preparing the System's
statements, suggested we provide an analysis of the accounting issues
involved to support our recommendation. This appendix contains a
discussion of the relevant accounting guidance in this area as well
as analyses of accounting arguments presented by the System in its
comments.
We do not believe including the Insurance Fund in the System's
combined financial statements results in the most appropriate
presentation of the System's financial condition. Our belief is
based on our review and analysis of applicable accounting guidance,
primarily that regarding combined financial statements and the
definition of an asset. This appendix also contemplates (1) how the
Insurance Fund should be presented on the Farm Credit System
Insurance Corporation's (FCSIC) GAAP-based financial statements and
(2) how the revolving fund--the Insurance Fund's predecessor--was
presented on the System's past GAAP-basis statements.
BACKGROUND
--------------------------------------------------------- Appendix I:1
The footnotes to the System's combined financial statements indicate
that they include the accounts of System banks, their related
associations, the Jackson Federal Land Bank (FLB), the Farm Credit
System Financial Assistance Corporation (FAC), the Insurance Fund,
and the allocated earnings of certain service organizations owned
jointly by System banks, by reason of the "financial and operational
interdependence" of the System banks and associations. In its
comments on a draft of this report, the Funding Corporation indicated
that the fundamental reason for preparing combined financial
statements for the System is that System banks are jointly and
severally liable for substantially all of the debt shown in these
statements. Since the amounts in the Insurance Fund represent
protection against default on these liabilities, and can only be used
to benefit the System, the Funding Corporation believes these assets
and related capital should be included in the System's statements.
The Funding Corporation noted that FCSIC obtains its premiums only
from System banks and does not completely indemnify them against risk
of loss since investors in Systemwide debt can, after the Insurance
Fund is depleted, look to System banks' joint and several liability
for repayment. The existence of the Insurance Fund does not, in the
Funding Corporation's view, transfer any risk of loss from System
banks to other parties. Thus, it believes the amounts in the fund
have characteristics similar to deposits. The Funding Corporation
considers FCSIC to be a special purpose entity set up to administer
the Insurance Fund. It sees the fund itself as a trust that can, by
statute, only be used for purposes that directly or indirectly
benefit the System as a whole. The Funding Corporation therefore
presents the Insurance Fund as a restricted System asset and capital
account. Individual System banks do not record any portion of the
Insurance Fund as capital.
ACCOUNTING GUIDANCE DOES NOT
FULLY SUPPORT SYSTEM'S
TREATMENT OF THE FUND
--------------------------------------------------------- Appendix I:2
We believe the implication in the System's financial statements that
the Insurance Fund is part of the assets and capital currently
available to the System to repay its liabilities is misleading. In
addition, we believe it is misleading to present the Insurance Fund
as an asset and capital on the GAAP-based financial statements of
both the System and FCSIC. On the basis of our review of applicable
accounting guidance, we do not believe it is fully justifiable under
GAAP to record the total Insurance Fund as an asset and as capital of
the System, even if shown as restricted accounts. However, since the
System has a legitimate claim on a portion of the assets in the
Insurance Fund related to the failure of the Jackson FLB, we believe
it is appropriate for the System to recognize this probable future
benefit in its combined financial statements.
FUND CHARACTERISTICS NOT
ENTIRELY CONSISTENT WITH
GAAP DEFINITION OF AN ASSET
------------------------------------------------------- Appendix I:2.1
The Funding Corporation's rationale for treating the Insurance Fund
as a System asset relies heavily on accounting guidance for the
definition of an asset. The Funding Corporation refers to Statement
of Financial Accounting Concepts (SFAC) No. 6, Elements of Financial
Statements. Paragraphs 25 and 26 of SFAC No. 6 define an asset as
follows:
"Assets are probable future economic benefits obtained or
controlled by a particular entity as a result of past
transactions or events. An asset has three essential
characteristics: (a) it embodies a probable future benefit that
involves a capacity, singly, or in combination with other
assets, to contribute directly or indirectly, to future net cash
inflows, (b) a particular entity can obtain the benefit and
control others' access to it, and (c) the transaction or other
event giving rise to the entity's right to or control of the
benefit has already occurred."
The board of directors of FCSIC, by law, has responsibility for
directing both the mandatory and permissive uses of the Insurance
Fund. The mandatory use is to ensure payment of principal and
interest on Systemwide debt and certain other securities should a
System institution be unable to meet its obligations. The permissive
uses include providing assistance to troubled System banks and
associations and covering FCSIC's operating expenses. The law gives
FCSIC's board of directors discretion to grant or deny assistance to
these System institutions and to purchase services and engage in
other transactions necessary to carry out FCSIC's purposes.
In effect, the System's access to resources from the Insurance Fund
is triggered only at such time as assets of a System institution
deteriorate to such a degree that assistance is required. We do not
believe a future benefit to the System from the Insurance Fund
becomes "probable" within the meaning of paragraph 26 of SFAC No. 6
until one or more System institutions' financial condition becomes
seriously deteriorated. This position is further supported by
paragraph 191 of SFAC No. 6 as follows:
"Since the transaction or event giving rise to the entity's
right to the future economic benefit must already have occurred,
the definition excludes from assets items that may in the future
become an entity's assets but have not yet become its assets.
An entity has no asset for a particular future economic benefit
if the transactions or events that give it access to and control
of the benefit are yet in the future." [Emphasis added.]
We believe the substance of FCSIC's Insurance Fund is one of
resources available only in the event System institutions experience
financial difficulty. Indeed, it is not inconceivable that the
Insurance Fund could be totally expended providing assistance to
problem banks or associations with no direct payment made from the
fund to satisfy insured System obligations. Therefore, the
implication in the System's financial statements that the Insurance
Fund is part of the assets currently available to repay Systemwide
debt is misleading. The Annual Information Statement issued by the
Funding Corporation with the System's 1992 financial statements
addresses this issue by disclosing that there is no assurance that
amounts in the Insurance Fund will be available to fund the timely
payment of principal and interest on insured System obligations.
As noted in chapter 2, after the assets of the Jackson FLB seriously
deteriorated, a contract was signed in 1990 that, in effect,
establishes a claim for replacement assets from the Insurance Fund.
This claim does represent a probable future benefit, as defined by
SFAC No. 6, to the System arising from past transactions and events.
In our view, only this portion of the Insurance Fund should be
presented as an asset on the System's combined balance sheet.
FINANCIAL STATEMENTS OF
FCSIC AND THE SYSTEM BOTH
PRESENT FUND AS ASSETS AND
CAPITAL
------------------------------------------------------- Appendix I:2.2
FCSIC issues separate GAAP-basis audited financial statements. In
these statements, the Insurance Fund is presented as assets and
capital of the entity FCSIC. To support its position that the
Insurance Fund should be treated as an asset and as capital of the
System, the Funding Corporation compares the Insurance Fund to a
trust and the amounts in the Insurance Fund to a deposit. We do not
believe either of these analogies is valid or that they are
consistent with the treatment of the Insurance Fund on FCSIC's
GAAP-basis statements. We believe it is misleading to present the
Insurance Fund as an asset and as capital of both the System and
FCSIC, and that it should be removed from the System's statements.
COMPARISON OF FUND TO
DEPOSIT NOT VALID
----------------------------------------------------- Appendix I:2.2.1
To support its position that amounts in the Insurance Fund have
characteristics of deposits, the Funding Corporation refers to the
accounting guidance on deposits of excess insurance premiums
discussed in Statement of Financial Accounting Standards (SFAS) No.
5, Accounting for Contingencies. Funds considered to be a deposit
asset on the books of the insured are carried as a liability on the
books of the insurance company,\1 which is not the case on FCSIC's
financial statements.
The Funding Corporation cites the following from paragraph 44 of SFAS
No. 5:
"To the extent that an insurance contract . . . does not,
despite its form, provide for indemnification of the insured .
. . against loss or liability, the premium paid less the
amount . . . to be retained by the insurer . . . shall be
accounted for as a deposit by the insured . . . . Those
contracts may be structured in various ways, but if, regardless
of form, their substance is that all or part of the premium paid
by the insured . . . is a deposit, it shall be accounted for
as such."
We do not believe the Insurance Fund presently contains any "excess"
amounts, since it had not reached its statutorily defined minimum or
"secure base" as of December 31, 1992. Therefore, in our view, SFAS
No. 5 does not support recording any portion of the Insurance Fund
as a liability of FCSIC at this time. In addition, the law is silent
on the disposition of FCSIC's net assets in the event the fund is
dissolved. It does not require FCSIC to return these amounts to the
System.
Moreover, we do not believe the Insurance Fund fits the definition of
a liability of FCSIC given in SFAC No. 6, the same guidance
discussed earlier for the definition of an asset. Paragraph 35 of
SFAC No. 6 defines liabilities as
"[P]robable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or
provide services to other entities in the future as a result of
past transactions or events."
Paragraph 168 of SFAC No. 6 clarifies this definition by stating
that
"An item does not qualify as a liability of an entity under the
definition in paragraph 35 if (a) the item entails no future
sacrifice of assets, (b) the item entails future sacrifice of
assets, but the entity is not obligated to make the sacrifice,
or (c) the item involves a future sacrifice of assets that the
entity will be obligated to make, but the events or
circumstances that obligate the entity have not yet occurred .
. . ." [Emphasis added.]
No event or circumstance that will obligate FCSIC to transfer any
significant portion of the assets in the Insurance Fund to the System
has yet occurred, except for the 1990 signing of the contract
obligating FCSIC to cover the cost of the Jackson FLB's failure, for
which a liability is now reflected on FCSIC's books.\2 Accordingly,
we do not believe the Insurance Fund balance can be properly treated
as a liability of FCSIC.
We do not believe the Insurance Fund currently contains any "excess"
amounts or that it fits the definition of a liability of FCSIC.
Therefore, we do not believe the Funding Corporation's comparison of
the Insurance Fund to a deposit is valid.\3
--------------------
\1 SFAS No. 97, Accounting and Reporting by Insurance Enterprises
for Certain Long-Duration Contracts and for Realized Gains and Losses
from the Sale of Investments, states: "Amounts received as payments
for investment contracts [which are defined in the statement as
contracts that do not transfer significant insurance risk] shall be
reported as liabilities."
\2 FCSIC's 1992 financial statements show two relatively small
liabilities in addition to the $166,444,000 "liability for estimated
insurance obligations" related to the Jackson FLB's failure. These
additional liabilities are $147,000 for accounts payable and accrued
expenses and $1,173,000 to retire eligible borrower stock in a
Production Credit Association in receivership.
\3 In its comments on a draft of this report, the Funding Corporation
also compared the amounts in the Insurance Fund to compensating bank
balances. These are amounts commercial banks require borrowers to
deposit as a condition of receiving a loan. They are typically
returned when the loan is repaid. Since the System is not currently
borrowing from FCSIC or from the federal government to fund its
operations, we do not believe this analogy is valid.
COMPARISON OF FUND TO
TRUST NOT VALID
----------------------------------------------------- Appendix I:2.2.2
The Funding Corporation also compares the assets in the Insurance
Fund to those of a trust. According to the American Institute of
Certified Public Accountants' publication Audits of Banks, trusts are
not assets of the trustee and are not to be included in the trustee's
financial statements. Using this analogy, FCSIC would not include
the Insurance Fund in its GAAP-basis financial statements. Therefore
the presentation of FCSIC's GAAP-basis financial statements is
inconsistent with the Funding Corporation's position that FCSIC is
simply a trustee.
To support its position that the Insurance Fund is, in essence, a
trust, the Funding Corporation compares it to a sinking fund.
According to The Handbook of Financial Markets, the term "sinking
fund" originally meant cash (or assets readily sold for cash) set
aside by an issuer to retire bonds at maturity. This source goes on
to note that in modern practice there is no literal sinking fund.
Instead, bonds with sinking fund provisions are redeemed, either by
the issuer or by a trustee, according to a set schedule before
maturity.\4 This is not the case with Systemwide debt securities; the
Insurance Fund's mandatory use is to retire such debt in an event of
default. In any case, investors in Systemwide debt do not have a
claim on the assets in the Insurance Fund similar to that on assets
set aside in sinking funds. As noted earlier, the Insurance Fund may
be totally expended providing assistance to troubled System banks or
associations, leaving no funds available to retire Systemwide debt
securities. Therefore, we do not believe the Funding Corporation's
position that the Insurance Fund is a trust is valid.\5
--------------------
\4 See The Handbook of Financial Markets, eds. Frank J. Fabozzi and
Frank G. Zarb (Homewood, IL: Dow Jones-Irwin, 1987), p. 254.
\5 In its comments on a draft of this report, the Funding Corporation
also drew analogies between the Insurance Fund and accounts set up to
hold prepayments on loans and escrow accounts.
CHARACTERIZATION OF FCSIC AS
A SPECIAL PURPOSE ENTITY
DOES NOT JUSTIFY SYSTEM
ACCOUNTING TREATMENT
------------------------------------------------------- Appendix I:2.3
We agree with the Funding Corporation that FCSIC can be said to be a
special purpose entity (SPE), and, accordingly, we acknowledge that
the Insurance Fund can be used only for purposes that directly or
indirectly benefit the System. We do not agree, however, that the
available guidance on SPEs provides adequate justification for the
System's accounting treatment of the Insurance Fund.
The Funding Corporation noted in its comments on the draft report
that if an SPE were found to have no real business purpose except to
facilitate a transaction on behalf of another reporting entity,
and/or the SPE had no real equity holders who were at risk, the legal
form of the SPE could be ignored for accounting purposes and the
transaction accounted for according to its substance. We generally
agree with this comment. However, although FASB has recognized this
accounting concept, there is currently little accounting guidance
applicable to SPEs.
We believe FCSIC meets the definition of an SPE cited by the Funding
Corporation in that FCSIC exists to benefit the System by
contributing to the security of debt securities in System
institutions. Also, FCSIC does not have equity holders in the usual
sense. This is because FCSIC is a public, not a private entity, and
thus does not issue capital stock. As discussed above, however, we
do not believe the Insurance Fund is currently available to the
System and should not be treated as a System asset. Rather, we
believe FCSIC's accounts should be included with those of the federal
government, as indeed they are. Therefore, in our view, the Funding
Corporation's argument that FCSIC is an SPE is not a valid
justification of the System's current accounting treatment of the
Insurance Fund.
PREDECESSOR TO INSURANCE
FUND WAS NOT INCLUDED IN
SYSTEM'S FINANCIAL
STATEMENTS
------------------------------------------------------- Appendix I:2.4
The System's GAAP-basis combined financial statements before January
1989 did not include the revolving fund, an account of FCA that was
the predecessor of the Insurance Fund, and was, as discussed in
chapters 1 and 2, transferred into the Insurance Fund in 1989. The
revolving fund was not funded by the System. The revolving fund
assets continue to be included in the Insurance Fund, which the
System now claims as an asset and capital.
While only System institutions currently pay premiums into the
Insurance Fund, the payment of such premiums is not voluntary. The
System's 1992 Annual Information Statement aptly characterizes FCSIC
premiums as assessments by a federal entity established to provide
assistance to System institutions. Moreover, the System did not
establish the Insurance Fund or the revolving fund voluntarily. The
System's relationship to the Insurance Fund is no different than that
of its predecessor.\6
Also, the purpose of the Insurance Fund is essentially the same as
that of the $260 million transferred from the revolving fund.
Therefore, there is no justification for a change in the System's
accounting treatment of the assets of the former revolving fund under
GAAP. Nor is there justification for a different accounting
treatment of premiums paid into the Insurance Fund.
--------------------
\6 The Funding Corporation points out that the System has control, in
part, because it can challenge FCSIC's failure to use the Insurance
Fund to cover defaults or FCSIC's use of the Insurance Fund for
unauthorized purposes. However, other parties besides the System are
also able to challenge FCSIC actions, as they can FCA actions, if
they believe them to be improper.
ACCOUNTING GUIDANCE DOES NOT
SUPPORT COMBINING FCSIC'S
ACCOUNTS WITH THE SYSTEM'S
------------------------------------------------------- Appendix I:2.5
The Funding Corporations's comments indicate that it does not believe
that any assets and liabilities presented in FCSIC's financial
statements, other than the Insurance Fund, should be included in
System's statements. We find this position inconsistent with the
Funding Corporation's position that since FCSIC is an SPE with no
real business purpose, all of its resources should be viewed as
System assets. In any case, including the Insurance Fund in the
System's financial statements has the same effect as combining the
accounts of the entity FCSIC with those of the System. We do not
believe existing accounting guidance supports this treatment.
Accounting Research Bulletin (ARB) No. 51, Consolidated Financial
Statements, is the primary GAAP guidance for preparing consolidated
and combined financial statements. Under ARB No. 51, common
ownership is needed to justify preparing "consolidated" statements,
but "combined" statements may be prepared where there is "common
management" or "common control" between two or more organizations:
"There are circumstances . . . where combined financial
statements [as distinguished from consolidated statements] of
commonly controlled companies are likely to be more meaningful
than their separate statements. For example, combined financial
statements would be useful where one individual owns a
controlling interest in several corporations which are related
in their operations . . . . They might also be used to
combine the financial statements of companies under common
management."
The accounts presented in the separate financial statements of FCSIC
should not be combined with those of System institutions under ARB
No. 51, since by law there can be no common management or control
between FCSIC and System institutions, individually or collectively.
Lack of control over administration of the Insurance Fund was the
basis for an FCA staff belief that the inclusion of the Insurance
Fund in the System's combined financial statements is not in
accordance with GAAP. Even though FCA has changed from this
position, as noted earlier, we continue to believe that this is an
appropriate position.
CONCLUSIONS
--------------------------------------------------------- Appendix I:3
We recognize that some arguments exist for including the Insurance
Fund in the System's financial statements. However, we believe that,
on balance, the arguments for excluding the Insurance Fund are
stronger and result in a more appropriate presentation of the
System's financial situation. We believe the overriding
consideration in determining the proper accounting treatment should
be that the impact of such treatment results in the most meaningful
presentation of the subject financial statements. We believe that
both the technical GAAP guidance as well as this principle of
meaningful presentation support excluding the Insurance Fund from the
System's financial statements.
INTEREST RATES CHARGED BY SYSTEM
INSTITUTIONS AND COMPETING SMALL
COMMERCIAL BANKS
========================================================== Appendix II
To assess the rates prevailing in agricultural credit markets, we
collected interest rate data and related information on new farm
loans originated during a sample week in each quarter of 1991 by
System associations in three midwestern districts. Each district was
then divided into local market areas (defined by an association's
chartered territory or by state). Similar data from small to
medium-sized commercial banks were then obtained from the Board of
Governors of the Federal Reserve System for all local markets for
which data were available.\1 Commercial bank data constraints limited
the total number of local market areas in the study to 12 out of a
possible 32. These 12 markets were distributed over 6 states.
The number of observations (new loans) in the System group totaled
1,852, of which 780 or 42.1 percent were classified as agricultural
real estate loans. The total number of observations in the
commercial bank group was 4,224, of which 134 or 3.2 percent were
classified as agricultural real estate loans.
--------------------
\1 Loan data obtained for commercial banks were limited to small and
medium-sized "agricultural" banks operating in the defined local
market areas. Agricultural banks are defined by the Federal Reserve
Board as any bank whose ratio of farm loans to total loans exceeds
the unweighted average of the ratio at all commercial banks on a
given date (16.49 percent on June 30, 1991). A minimum of three
agricultural banks was sampled in each market. All sampled banks had
less than $500 million in total assets.
MEAN INTEREST RATES AT SYSTEM
INSTITUTIONS ARE LOWER THAN AT
SMALL COMMERCIAL BANKS
-------------------------------------------------------- Appendix II:1
For each market area we computed the mean effective interest rate on
operating loans, by quarter, charged by System institutions and the
competing commercial banks.\2 A statistical test was then conducted
to determine if significant differences existed between the mean
quarterly effective interest rate of each lender. The results of
this test appear in table II.1.
Table II.1
Mean Effective Interest Rates on Farm
Operating Loans in Selected Midwestern
Local Markets, 1991
FCB/ Quarte
Area r System Banks System Banks Difference
-------- ------ ------ ------ ------ ------ ----------
A/1 1 36 30 10.74 12.03 -1.29\a
2 18 30 9.98 11.62 -1.64\a
3 13 37 10.62 11.57 -0.95\a
4 12 37 9.77 10.86 -1.10\a
A/3 1 25 101 10.79 12.01 -1.22\a
2 10 91 10.15 11.39 -1.24\a
A/4 1 46 21 10.86 11.09 -0.23
3 11 23 10.32 10.97 -0.65\b
4 14 24 9.21 10.52 -1.31\a
A/5 1 35 15 10.51 12.11 -1.60\a
2 36 22 10.33 10.89 -0.56
3 23 20 9.94 10.94 -1.00\a
4 17 16 9.70 10.34 -0.64\b
A/6 1 15 22 10.51 11.13 -0.62
2 23 47 10.65 10.86 -0.21
3 17 28 10.10 11.07 -0.97\a
4 25 24 9.40 10.48 -1.08\a
B/8 1 41 361 11.54 11.81 -0.27
4 11 270 10.49 11.15 -0.66\b
B/9 1 33 178 11.40 11.74 -0.34\a
2 17 170 11.16 11.40 -0.24
4 13 132 10.58 10.87 -0.29
B/10 1 12 129 11.61 11.40 0.21
4 18 259 10.50 10.62 -0.12
C/24 1 22 23 12.32 12.72 -0.40
2 22 20 11.96 12.57 -0.61\a
4 12 34 11.09 11.18 -0.09
C/26 1 28 104 11.93 12.14 -0.21
2 14 98 11.62 11.78 -0.16
4 13 103 11.07 10.73 0.34
------------------------------------------------------------
Note: "Difference" equals System minus Banks.
\a Statistically significant at a 1-percent level of confidence.
\b Statistically significant at a 5-percent level of confidence.
Source: GAO.
In selecting market areas and time periods in which to make these
comparisons, we eliminated all those with fewer than 30 observations
or fewer than 10 loans from both System institutions and small banks.
While there were too few observations to make comparisons in every
quarter for all market areas, the results obtained indicated that the
mean effective interest rate charged by System institutions was
either lower than, or not statistically different from, the mean
effective interest rate charged by commercial banks in every instance
where direct comparisons were possible. The mean rate charged by
System institutions was never significantly higher than the mean rate
charged by competing commercial banks in the same quarter. In 8 of
the 10 areas, the difference in mean rates was statistically
significant in at least one quarter during 1991. Although the
magnitude of the interest rate differential varied over time and by
market area, one local market (area 1) exhibited a large and
significant difference in all four quarters of 1991. Several others
also exhibited large differentials in mean effective rates between
the two lenders.
We regard this evidence as only suggestive. Because the data were
drawn from only a sample of loans in each quarter and because only a
small number of commercial banks from each market were surveyed, the
results may not be representative. Additionally, because of the
limitations associated with an analysis involving averages, we were
not able to determine if the differences were due to variations in
the characteristics of the loans or to real systematic pricing
differences between the lenders. Yet, the results from the means
analysis are at least consistent with the interest rate structure
suggested by the national data, in which System rates on operating
loans are, on average, slightly below those of small to medium-sized
banks.
--------------------
\2 The effective interest rate was defined as the nominal rate of
interest adjusted for the frequency of interest compounding and the
System stock purchase requirement. We assumed no dividends were paid
on the stock over the life of the loan.
REGRESSION ANALYSIS REINFORCES
FINDING THAT SYSTEM INTEREST
RATES ARE LOWER THAN SMALL
COMMERCIAL BANK RATES
-------------------------------------------------------- Appendix II:2
Since individual loan characteristics could cause the means
comparisons to be misleading, we attempted to determine if the
observed differences in interest rates persisted once we controlled
for the possible effects of several other potentially influential
factors. To do this, we employed multiple regression analysis to
test the relationship between the effective interest rates on
individual loans and a dummy variable that identified the lender,
while controlling for the effects of time, location, and various
other attributes of the individual loans (see table II.2 for variable
definitions).\3 With this technique, we could use data for all 12
market areas and all 4 quarters of 1991. Since the agricultural
credit market is for the most part segmented into real estate and
nonreal estate markets, separate regressions were run for
agricultural real estate loans and operating loans.
Results from our regression analysis indicated that System rates on
both types of loans were lower on average than rates on similar loans
made by small to medium-sized commercial banks (see table II.3). For
operating loans, System rates were estimated to be approximately 0.59
percentage points less than interest rates charged by competing small
to medium-sized banks in the sample. For agricultural real estate
loans the difference was somewhat greater, with effective interest
rates at System institutions being 0.99 percentage points less than
rates at competing small banks. The larger difference observed on
agricultural real estate rates is consistent with the argument that
the System has an advantage in making long-term loans due to its
lower cost of funds. This is reflected by the System's large market
share in agricultural real estate lending.
Not surprisingly, the results also indicate that interest rates
generally declined over the year and that rates varied considerably
between individual markets, by the size of loan, and by the maturity
(length) of the loan.
The adjusted R-square values associated with our regression model are
somewhat lower than would be desirable (0.5798 for the real estate
equation and 0.2830 for the nonreal estate equation).\4
The magnitude of the adjusted R-square indicates that a considerable
amount of the variation in observed interest rates remains
unexplained by the variables used in our model.
Hence, because of the limited data available to us and because of the
relatively low explanatory power of the regression model, these
results do not allow us to conclusively determine if the differences
between interest rates were purely lender-related, as suggested by
the significance and magnitude of the SOURCE variable coefficients,
or if some unknown borrower characteristics (such as
creditworthiness) and/or nonprice competitive factors were
responsible for all or part of the disparity.
In summary, while our statistical analyses did not uncover conclusive
evidence indicating that interest rates on new loans originated in
1991 by System institutions were less than rates charged by small to
medium-sized commercial banks for similar loans, the bulk of the
evidence suggests that this is the case. Our results are consistent
with the prevailing interest rate structure suggested by the national
summary data collected by the U.S. Department of Agriculture in
which System rates averaged somewhere between rates charged by large
and small to medium-sized commercial banks.
As previously mentioned, tables II.2 and II.3 contain our multiple
regression analysis variable definitions and results.
Table II.2
Farm Loan Interest Rate Regression Model
Variables
Variable name Definition
------------------ ----------------------------------------
RATE Effective loan rate. This is the
dependent variable of the regression.
SOURCE Lender. This is a dummy variable equal
to 1 if the lender is a commercial bank
or 0 if a System institution.
Qnn Quarter. These three dummy variables
equal 1 if the loan was made in the
quarter, otherwise 0.
AREAnn Local market area. These 11 dummy
variables equal 1 if the loan was made
in the area, otherwise 0.
LTYPE Loan type. This is a dummy variable
equal to 1 if the interest rate on the
loan is fixed, otherwise 0.
GSTAT Guarantee status. This is a dummy
variable equal to 1 if the loan is
guaranteed by the federal or a state
government, otherwise 0.
SIZEn Loan size. These five dummy variables
define the following size classes. SIZE1
equals $10,000 to $24,999; SIZE2,
$25,000 to $49,999; SIZE3, $50,000 to
$99,999;
SIZE4, $100,000 to $249,999; and SIZE5,
$250,000 or more.
MATnnn Maturity or length of the loan. These
four dummy variables define the
following maturity classes. MAT13 equals
1 year to less than 3 years; MAT35, 3
years to less than 5 years; MAT510, 5
years to less than 10 years; and MAT10,
10 years or more.
------------------------------------------------------------
Source: GAO.
Table II.3
Farm Loan Interest Rate Regression Model
Results
Variable Estimate t STAT Estimate t STAT
-------------------- -------- -------- -------- --------
INTERCEPT 11.890\a 42.490 11.778\a 125.320
SOURCE 0.987\a 10.679 0.589\a 12.071
Q2 - -3.923 - -8.986
0.302\a 0.331\a
Q3 - -3.494 - -10.125
0.314\a 0.396\a
Q4 - -9.285 - -23.282
0.792\a 0.903\a
AREA2 -0.020\ -0.117 -0.064 -0.218
AREA3 0.188 1.238 0.057 0.754
AREA4 -0.038 -0.230 - -3.512
0.311\a
AREA5 -0.248 -1.696 - -4.153
0.367\a
AREA6 -0.025 -0.172 - -5.304
0.458\a
AREA8 -0.036 -0.264 0.172\a 2.599
AREA9 0.133 0.944 0.102 1.449
AREA10 0.177 1.155 - -2.691
0.192\a
AREA24 0.378\b 2.024 0.821\a 8.802
AREA26 -0.098 -0.462 0.408\a 4.087
AREA29 0.665\a 3.094 1.176\a 9.963
LTYPE -0.044 -0.594 -0.012 -0.368
GSTAT 0.727\a 4.712 0.106 1.244
SIZE1 -0.039 -0.362 - -4.826
0.173\a
SIZE2 -0.159 -1.671 - -7.615
0.370\a
SIZE3 - -5.172 - -8.606
0.500\a 0.502\a
SIZE4 - -5.054 - -5.370
0.528\a 0.427\a
SIZE5 - -5.029 - -3.768
0.725\a 0.580\a
MAT13 0.380 1.356 - -2.008
0.167\b
MAT35 -0.319 -0.979 - -3.162
0.286\a
MAT510 - -3.809 - -4.638
1.001\a 0.391\a
MAT10 - -5.433 - -8.575
1.300\a 0.644\a
R-SQUARE 0.5971 0.2874
ADJ R-SQUARE 0.5798 0.2830
F VALUE 34.536 64.871
PROB/>F 0.0001 0.0001
------------------------------------------------------------
\a Statistically significant at a 1-percent level of confidence.
\b Statistically significant at a 5-percent level of confidence.
Source: GAO analysis of Farm Credit System and Federal Reserve Board
data.
(See figure in printed edition.)Appendix III
--------------------
\3 Use of the dummy variable method to ascertain the various effects
of different explanatory variables requires some care in
interpretation. For example, all parameter estimates in our equation
indicate to what extent the intercept value would be affected if that
particular loan characteristic were applicable and all other effects
were held constant. The interpretation is straightforward in the
case of the SOURCE, LTYPE, and GSTAT variables, i.e., a real estate
loan originated by a commercial bank (SOURCE=1) is estimated to be
0.987 percentage points greater than one that is originated by a
System institution. However, the interpretation of the parameter
estimates associated with the dummy class variables, which
characterize loans by quarter (Q), local market area (AREA), size
(SIZE), and maturity (MAT), must be interpreted relative to a
preselected intercept value. In our model, the coefficient of the
intercept is estimated for a relatively small loan (SIZE0: less than
$10,000) originated in market area No. 1 (AREA1) during the first
quarter of 1991 (Q1) and which has a maturity of less than 1 year
(MAT01). Hence, the parameter estimate of the variable SIZE5, for
example, reflects the percentage point difference in the interest
rate between a small loan (less than $10,000) and a relatively large
loan ($250,000 or more). For real estate loans, this difference is
-0.725 percentage points. That is, the interest rate on farm real
estate loans greater than $250,000 is roughly three-quarters of a
percentage point less than a similar loan made for less than $10,000.
\4 The R-square value is a measure of the explanatory power of the
model (with a value of 1 being the maximum). The adjusted R-square
value is a related measure that takes into consideration the number
of explanatory variables used in the equation.
COMMENTS FROM THE FARM CREDIT
SYSTEM
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
and comment 4.
(See figure in printed edition.)
and comment 5.
(See figure in printed edition.)
and comment 6.
p. 77.
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
and comment 1.
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
and comment 15.
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the Farm Credit System's letter
dated April 1, 1993.
GAO COMMENTS
-------------------------------------------------------- Appendix II:3
1. We did not reproduce either of these addenda in this report. In
appendix I, we present and discuss the Funding Corporation's position
on Insurance Fund accounting issues put forth in the first addendum
to the System's comments. The technical comments in the second
addendum were incorporated directly into the text where appropriate.
2. Our final report was revised to remove this implication reference
but we retain the point that the Contractual Interbank Performance
Agreement (CIPA) standards, which all System banks have agreed to,
more clearly recognize the current effect the obligation for
assistance repayment has on bank capital positions.
3. We have revised the report to clearly identify that the System
has used and is obligated to repay the $1.261 billion for bonds
issued to fund the assistance authorized under the 1987 act. In
addition, the System must provide funds to reimburse the Treasury for
advancing it interest payments for these bonds, estimated at $444
million to $580 million.
4. In our view, the way the Omaha Farm Credit Bank (FCB), AgriBank,
and FCSIC accounted for the transactions cited here provides no
support for System banks' practices in general. These transactions
are related to specific obligations of particular entities that are
not the same as those of System banks in general.
5. For the effects of structural change, one such change encouraged
by the 1987 act is the conversion of associations from Federal Land
Bank Associations (FLBA) to Agricultural Credit Associations (ACA) or
Federal Land Credit Associations (FLCA). This means that FCBs
increasingly operate as "wholesale" rather than "retail" lenders.
Structural change of this kind increases the distortion of System
banks' regulatory capital that results from the accounting and
regulatory relief granted for assistance repayment.
6. We clarified the text in the report to better express our concern
with this aspect of the regulatory relief granted by the 1992 act.
We noted that if weak banks delay making annual payments to FAC for
the capital preservation agreement (CPA) payables assistance, a
serious distortion of regulatory capital could result. We also noted
that a weak bank's appearance of adequate capital might undermine FCA
efforts to correct related performance problems.
7. As noted on page 46, in designing their CIPA program, System
banks took a different position on the nature of the assistance
preferred stock and the related appropriated surplus accounts than
presented here.
8. As discussed in chapter 1 on page 24, the Insurance Fund has, in
effect, already been tapped in connection with the liquidation of the
Jackson FLB. In this sense, amounts in the Insurance Fund (which
include the $260 million transferred from the revolving fund) have
been invested in a System institution in connection with the 1987 act
assistance program. In chapters 2 and 5 and in appendix I, we
explain why we believe the System should acknowledge this fact now.
9. As FCSIC noted in its comments, Congress required commercial
banks to repay the amounts the federal government contributed in the
1930s to the deposit insurance fund. Congress also did so later, in
the 1950s, when it required System institutions to begin repaying the
taxpayer money they had earlier received as start-up capital.
10. We made only one formal recommendation in the draft report, the
first one the System cites on page 10. This is essentially the same
recommendation we make on page 52 of chapter 2. However, the System
is correct in pointing out that in the draft report, we concluded
that the System's combined financial statements for 1989-1991 should
be restated. As discussed in chapter 5 on page 80, we did not
emphasize this in our final report.
11. In our view, the System's current accounting treatment of
FCSIC's Insurance Fund is not the most appropriate GAAP treatment.
In the draft report, we emphasized the fact that FCSIC premiums and
the Insurance Fund are on-budget to make clear that the statutory
mechanisms under discussion constitute a federal insurance program
for System institutions. We added that they are not a form of self
insurance to make this distinction more apparent in chapter 2.
We also added footnote 23 on page 48 of chapter 2 to clarify that the
amounts in the Insurance Fund have the same budget classification as
the assessments System institutions pay to cover FCA's operating
expenses, namely "public enterprise funds."
Finally, as discussed in appendix I, we do not believe it is
appropriate to characterize FCSIC as simply a trustee for the System,
and we did not do so in the final report.
12. We believe the Funding Corporation is correct in pointing out
that, ideally, those most knowledgeable about the practices of
entities issuing GAAP-based financial statements should make
determinations as to the most appropriate accounting treatments for
particular transactions. However, as noted in chapter 5, in the case
of virtually all large private issuers of securities in the U.S.
financial markets, the Securities and Exchange Commission (SEC)
reviews these determinations and has the authority to require changes
in particular entities' accounting practices.
The System is one of the government-sponsored enterprises (GSE)
exempt from these SEC reviews, but not from similar reviews by FCA.
The SEC certainly has more experience in reviewing the financial
reports of major U.S. corporations than FCA does. Nevertheless, we
believe FCA has the statutory authority to review the System's
financial statements to ensure that they are prepared in accordance
with GAAP, and, if it determines that they are not, to require
changes.
Of course, this does not give FCA the authority or the duty to set
GAAP. We did not mean to suggest that any of the federal bodies
cited here set GAAP for private firms. However, we have certain
responsibilities for establishing accounting principles for public
entities. Indeed, one of the major GSEs--the Federal Home Loan Bank
System--currently prepares its combined financial statements in
accordance with these standards.
13. We added appendix I to this final report in response to this
comment as well as comments from FCA and FCSIC. This appendix
discusses the Funding Corporation's position and our views as to the
proper interpretation of GAAP with respect to FCSIC's Insurance Fund
in detail. As noted on page 92, we concluded that the System's
current treatment is not the most appropriate one under GAAP.
14. In the draft report, we identified accounting for the Jackson
FLB as a problem related to Insurance Fund accounting, stated the
Funding Corporation's rationale for its treatment of the Jackson FLB
assistance in this context, and noted that FCA had not formally
addressed this issue. The Funding Corporation omitted these
statements from the quotation from the draft report it analyzed.
This passage now appears on page 50 and 51.
Nowhere in the draft report did we suggest that the System record a
liability for the Jackson FLB. On the contrary, as noted in this
final report on page 51 and elsewhere, we believe the System's
combined financial statements should reflect FCSIC's commitment to
pay the costs of liquidating this bank as an asset. The question of
restating the System's past financial information is addressed in
comment 10.
We also edited other parts of chapter 2 in response to the technical
points the Funding Corporation raised with regard to other accounting
issues. These changes did not affect the substance of our final
report.
15. We did not indicate the System's support for this alternative in
the draft report because Funding Corporation officials did not
mention it to us during our review.
16. Even if System institutions provide competitive returns on
equity for their member-borrowers, as noted on page 62, the tax
advantages available to System institutions enable them to retain or
distribute more of their earnings than most of their competitors can.
In this sense, System institutions do have a competitive advantage in
required profit margins.
17. We focused only on the major lenders to agriculture named in the
statute that required us to conduct this study: the System,
commercial banks, and insurance companies. As illustrated in figure
1.3, these lenders currently hold more than three-fourths of total
U.S. farm debt.
(See figure in printed edition.)Appendix IV
COMMENTS FROM THE FARM CREDIT
ADMINISTRATION
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
and comment 2.
(See figure in printed edition.)
The following are GAO's comments on the Farm Credit Administration's
letter dated April 2, 1993.
GAO COMMENTS
-------------------------------------------------------- Appendix II:4
1. We took these new provisions of the 1992 act into account in the
course of updating the analysis cited here from June 30 to December
31, 1992. This analysis now appears on pages 42-43.
2. Subsequent to this comment letter, FCA and the System reached an
agreement on added disclosure of information on the Insurance Fund in
the notes to the System's combined financial statements, which caused
FCA to change this position. In December 1993, the System proposed a
form of disclosure for the Insurance Fund that, according to FCA,
resolves its concerns about this issue. After FCA formally accepted
this proposed form of disclosure, the FCA Board approved a proposed
regulation on disclosure to investors that incorporates the System's
proposed disclosure format for the Insurance Fund.
(See figure in printed edition.)Appendix V
COMMENTS FROM THE FARM CREDIT
SYSTEM INSURANCE CORPORATION
========================================================== Appendix II
and comment 1.
(See figure in printed edition.)
(See figure in printed edition.)
The following is GAO's comment on the Farm Credit System Insurance
Corporation's letter dated April 2, 1993.
GAO COMMENT
-------------------------------------------------------- Appendix II:5
1. We agree with FCSIC and FCA that the Treasury interest advances
represent an economic benefit to the System that should be recorded
as such. However, we believe this benefit should be reflected in the
accounting entries for the main categories of assistance. We do not
believe the System's current practice of recording a separate
liability for the advances themselves is the most appropriate GAAP
treatment.
(See figure in printed edition.)Appendix VI
COMMENTS FROM THE AMERICAN BANKERS
ASSOCIATION
========================================================== Appendix II
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
(See figure in printed edition.)
The following are GAO's comments on the American Bankers Association
(ABA) letter dated March 30, 1993.
GAO COMMENTS
-------------------------------------------------------- Appendix II:6
1. We regret the confusion that arose over the language used in the
definition of "predatory pricing" at various points in the report.
We edited the sentence from the executive summary to make it conform
more closely with the phrasing used in chapter 2. We discuss FCA's
definition further in comment 2.
2. In this final report, we tried to make a clearer distinction in
chapter 3 between the economic analysis we designed and conducted on
the one hand and our review of FCA's investigations of System loan
pricing practices on the other.
As noted in chapter 5, we acknowledge that the standard economic
analysis we conducted does not establish that there is no predatory
pricing within the U.S. agricultural credit market under all valid
definitions of that term. Our review of the economic literature on
predatory pricing, including one study specifically addressing
competition between public and private organizations, now appears on
page 53 of chapter 3.
3. We believe, as stated on page 56 of this final report, that FCA's
definition of predatory pricing is not, as asserted by ABA, contrary
to applicable law. The standard ABA suggests--based on the "below
competitive market rates" language of the policy section of the Farm
Credit Act--was not intended by Congress as a definition of predatory
pricing. Rather than addressing System loan rates within the context
of predatory pricing, the policy statement was intended to address
concerns over possible dissipation of System capital due to charging
below market rates such as those set using average-cost pricing
during the late 1970s and early 1980s.
The legislative history of the policy section indicates that Congress
intended to invest substantial discretion in FCA to oversee the
safety and soundness of System loan pricing practices and did not
intend to constrain FCA's regulatory authority to the literal terms
of the policy statement in the statute. For example, the House
Agriculture Committee noted that while the policy statement indicated
factors to be considered with respect to System loan rates, it was
not a provision of positive law and did not purport to constitute a
formula for the determination of such rates.
4. We edited chapter 3 of this final report in an attempt to clarify
our analysis and conclusions. However, we did not change our earlier
position that, with few exceptions, System institutions have not
engaged in predatory pricing.
5. We agree that whether the System is needed today is a legitimate
question. Clearly, much in rural America has changed since the
System was created 75 years ago. In our view, the answer to this
question is a matter of judgment--it needs to be addressed in the
context of the nation's rural development agenda. We added a
statement to this effect to our conclusions in chapter 4.
We also edited the passage referred to here to make clear that
expanding the System's charter beyond agriculture is one way, but not
the only way, for System institutions to achieve the efficiences that
may be needed for them to remain viable. It appears on page 72,
which now notes that updating the System's charter and further
consolidation also support this goal.
MAJOR CONTRIBUTORS TO THIS REPORT
========================================================= Appendix VII
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
------------------------------------------------------- Appendix VII:1
William J. Kruvant, Assistant Director
Carol Kalin Bevan, Evaluator-in-Charge
Kenneth D. Jones, Economist
Robert Pollard, Economist
Susan Westin, Economist
Gordon Agress, Social Science Analyst
Dion Anderson, Evaluator
Charles Roberts, Advisor
ACCOUNTING AND INFORMATION
MANAGEMENT DIVISION,
WASHINGTON, D.C.
------------------------------------------------------- Appendix VII:2
Linda M. Calbom, Assistant Director
Laura Triggs, Accounting Manager
OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C.
------------------------------------------------------- Appendix VII:3
Lynn H. Gibson, Associate General Counsel
Geoffrey Hamilton, Attorney/Advisor
RELATED GAO PRODUCTS
============================================================ Chapter 1
Farm Credit System: Farm Credit Administration Effectively Addresses
Identified Problems (GAO/GGD-94-14, Jan. 7, 1994)
Government-Sponsored Enterprises: Changes in Securities Distribution
Process and Use of Derivative Products (GAO/GGD-93-70BR, Mar. 16,
1993)
Rural Credit: Availability of Credit for Agriculture, Rural
Development, and Infrastructure (GAO/RCED-93-27, Nov. 25, 1992)
Inspectors General: Issues Involving the Farm Credit
Administration's Chairman and IG (GAO/AFMD-92-27, Nov. 29, 1991)
Government-Sponsored Enterprises: Using Private Risk Ratings for
Exemptions From Federal Regulations (GAO/GGD-92-10, Nov. 6, 1991)
Federal Agricultural Mortgage Corporation: Potential Role in the
Delivery of Credit for Rural Housing (GAO/RCED-91-180, Aug. 7, 1991)
Government-Sponsored Enterprises: A Framework for Limiting the
Government's Exposure to Risks (GAO/GGD-91-90, May 22, 1991)
Failed Banks: Accounting and Auditing Reforms Urgently Needed
(GAO/AFMD-91-43, Apr. 22, 1991)
Deposit Insurance: A Strategy for Reform (GAO/GGD-91-26, Mar. 4,
1991)
Government-Sponsored Enterprises: The Government's Exposure to Risks
(GAO/GGD-90-97, Aug. 15, 1990)
Farm Credit: Basis for Decision Not to Assist Jackson Federal Land
Bank (GAO/GGD-90-16, Dec. 13, 1989)
Options for Dealing with Farm Credit System Problems
(GAO/T-GGD-87-11, Apr. 7, 1987)
Farm Credit: Actions Needed on Major Management Issues
(GAO/GGD-87-51, Apr. 1, 1987)